MARKET UPDATE 10/10/2022

Market sentiment: Continuing unease. After a relatively stable week on global financial markets, investors are bracing themselves for potential fireworks later this week. Unhappily for the Bank of England and the U.K Treasury, it is these two institutions that are under most scrutiny. The BoE’s ￡65bn emergency gilt purchase program ends on Friday. This has created a deadline for the Chancellor of the Exchequer, Kwasi Kwarteng to convince a sceptical bond market that he is serious about stability and predictability in fiscal policy. Markets are nervous that Mr Kwarteng will not deliver.

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Economists continue to reduce their GDP growth estimates for this year and for next. This is now feeding through into reduced corporate earnings growth forecasts for the coming quarters, adding to the pressure on equities coming from higher interest rates.

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Investor response: quality, quality, quality. Now is not the time to be ‘bottom fishing’ for distressed risk assets, particularly anything that is weighed down by too-much debt. Equally, investors in debt ie, fixed income investors), should perhaps be favouring creditors with strong balance sheets and -if invested in sovereign government bonds- a history of fiscal prudence. The watchword is ‘quality’.

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But economics and markets are never static. A portfolio that is devoid of riskier assets is not properly diversified. There will be an upturn in the global economy, in the future, that rewards investors in long-duration assts such as tech and long dated bonds. As interest rates start to fall, leveraged assets that have survived will be attractive again. Investors need to maintain exposure to the inevitable upturn.

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The consequences for markets of U.K policy disarray. If markets are unconvinced by the U.K Treasury, gilt prices are likely to fall (and their yields rise) as investors sell. This will, in turn, depress the pound. We may also see a sell-off in U.S Treasuries and other major bond markets, as we saw in late September.

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This is because investors are increasingly nervous that global interest rates may be higher, for longer, than currently priced in. (For example, the ECB last week warned of loose fiscal policies from governments creating an embedded inflation problem. The report cited the U.K and Germany in particular, but investors are also concerned about U.S fiscal policy being too stimulative).

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‘Higher for longer’ inflation and interest rates could expose other weaknesses in the financial system, given the large amount of debt taken on by governments and households, and parts of the corporate/financial sector, over the last decade. It is unlikely that the UK defined benefit pension fund sector is the only place where leveraged bets are going to go wrong as global mortgage and other borrowing rates rise above the levels previously expected.

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Investors’ resentment of positive growth data is logical. Later this week we have the minutes of the last Fed meeting, followed by September’s inflation data. Both could upset the markets, if they reinforce the ‘higher for longer’ theme for inflation and interest rates. Note how last week’s September monthly payroll data showed a sharp decline in new jobs (to 263,000), yet it led to sharp falls on Wall Street that was hoping for a still sharper drop in job numbers. Investors want the current inflation and interest rate cycles to be over as soon as possible, anything that extends it is a Bad Thing.

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Sterling will rise again, but don’t hold your breath. We are frequently reminded by U.K government spokespeople that nearly all currencies have fallen against the dollar this year, in part because the Fed has been the most aggressive of the major central banks in raising interest rates. This seemingly absolves the U.K government of the humiliation of seeing sterling fall to $1.03, in the chaos that followed Kwasi Kwarteng’s mini-budget three weeks ago.

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But domestic factors were clearly also at play. After all, the U.K has had the second largest interest rate hikes, after only the Fed, in the current cycle. It has tightened monetary policy much more severely than the ECB, for example. And yet sterling had fallen further than the euro, and to levels comparable with the Turkish lira and the yen -neither of which have seen any central bank tightening.

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Currency markets have been wary of sterling all year, as a current account deficit balloons, the government appeared intent on a trade war with the E.U (over the Northern Ireland Protocol), and GDP growth slowed. Liz Truss’s leadership campaign added the risk of loose fiscal policy, with unfunded tax cuts. This would add to the budget deficit, and fuel demand that would stoke inflation and suck in imports, so making the budget deficit worse. Few economists believe this strategy will help achieve a long-term GDP growth rate of 2.5%, because large deficits and a higher inflation risk will reduce investment incentives and call -eventually- for tough fiscal and monetary medicine.

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It is likely that sterling will rally when a new global economic cycle kicks in. Most economists expect this to be triggered by recovery in the U.S economy, once the Fed has stopped bearing down on inflation. When this happens, and the Fed starts to ease its monetary policy, it is likely the dollar will weaken against all but the most mismanaged currencies (the Turkish lira?) as investors anticipate a global economic recovery that will lift all boats.

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The extent of the recovery in sterling will depend on the U.K government showing a more conservative approach to public finances. Prime Minister Liz Truss has a history of policy U-turns, and may yet persuade currency traders that she and her chancellor are interested in fiscal stability. But the reality is that the current government appears wedded to discredited economic thinking, and it will be the next government’s job to offer the reassurance that gilt and currency investors are looking for.

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U.K assets look cheap. Despite the jokes about sterling resembling an emerging market currency, the U.K is home to a large number of high quality companies. These look cheap relative to overseas equities on a price/earnings (P/E) basis - JPMorgan Asset Management estimate that the U.K main market trades on a forward P/E of under 10 times, the lowest it has been since the early 1990s, and lower than any other investment region)*.

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A weak pound, that may well recover in due course, makes them look still cheaper to an overseas investor. The same can be said of U.K property, private equity and other assets.?Add to this the defensive nature of the leading quoted companies in the U.K (e.g, energy, mining, financial, pharma, utilities etc dominate the FTSE100 index), and the stock market looks attractive relative to many of its peers.

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Criticism of trickle down economics.?A cynic might observe that the main group of people who benefit from ‘trickle down economics’ (ie, tax cuts for the rich, intended to boost their spending and investment in the broader economy), are the wealthy. The same individuals who tend to vote for, and donate to, the ruling Conservative Party.

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The case against ‘trickle down economics’ has been made by a London School of Economics report in 2020**, which found tax cuts had zero statistical impact on growth in 18 cases looked at around the world over 50 years. This reflected the need to tax hikes elsewhere, or cut public spending, if the tax cuts are to be funded. If unfunded, such as the U.K government’s latest proposals, then higher borrowing costs occur as the deficit swells, acting as a curb on economic growth.