Investors are approaching the end of this week with some trepidation. It is fully justified.
We have the release of the minutes from the Fed’s September meeting, an event that frequently alters the mood of the markets. Tomorrow also sees the release of September’s U.S. inflation data – will core inflation still be rising, leading to higher Fed interest rates than are priced in by the market?
Also over the coming days are the big U.S. banks third quarter earnings results, with the all-important statements on the outlook for their businesses. We will learn about the demand for loans, and changes in rates in default, which indicate trends in the broader economy.
But the big event is undoubtedly on Friday, when global investors will be focused on the U.K. gilt market (the name given to U.K. government bonds). The Bank of England is playing chicken with the government over policy, the gilt market may tumble if neither side gives way. A knock-on hit to sterling would follow (as overseas investors sell their gilt holdings), and other major bond markets may fall.
But while investors are right to be nervous, they should avoid a knee-jerk response.
The nervous background
News flow in recent months has pushed out estimates for when inflation and interest rates in the major economies will peak, with the slogan ‘higher for longer’ now being applied to both. This reflects the problem of stubborn core inflation (notably in the U.S.), which is being driven by tight labour markets. In response, central banks are having to raise interest rates higher than had been expected, which increases the risk of recession.
Equity investors have some protection from inflation, if companies can pass on higher input costs to their customers. But they have little protection from a fall in turnover, and profits, as higher interest rates both squeezes demand and increases financing costs.
Meanwhile, fixed income investors are becoming anxious over the risk of an embedded inflation problem emerging and are looking to be compensated by demanding higher bond yields.
They also worry about oversupply, stemming from large government deficits, and the lack of interest of the G7 countries in curbing the deficits. The unwinding of central bank’s asset purchase schemes (‘quantitative tightening’ or QT) adds to fears of a looming glut of bonds.
The strong dollar aggravates the macro-economic gloom. It is function of aggressive rate hikes by the Fed this year, compared to other central banks, and its traditional role as a safe haven during times of geo-political uncertainty. While it helps moderate U.S. inflation, as imports become cheaper, it is inflationary for the rest of the world given that most energy and food is traded on global markets in dollars.
Countries that have borrowed heavily in dollars are particularly badly affected. The cost of servicing and repayment of the debts has gone up in local currency terms, and new borrowing comes with a much higher interest rate.
UK government policy: pouring oil on the flames
Given the above uncertainty in the global economy, the U.K. government might have thought twice before recently announcing a package of £45bn unfunded tax cuts on top of a £150bn energy subsidy scheme, in an attempt to support growth. Many economists believe it will simply make the Bank of England’s task of bringing down inflation harder, extending the ‘higher for longer’ outlook for interest rates.
The government’s willingness to take on more debt to finance an unorthodox growth policy, that runs counter to the policy of its central bank, suggested to some investors a cavalier approach to public finances and to the economy.
The immediate sharp sell-off of gilts and sterling led to the Bank of England stepping in with a £65bn bond buying programme, aimed at restoring stability on the gilt market. It was forced to do so by U.K. pension funds, whose leveraged investments in gilts had come unstuck by the sudden fall in their value.
Twice this week the Bank of England has added to the programme, by introducing a repo facility (offering short term cash loans in return for assets) and expanding the range of what assets it will buy in the £65bn programme. Clearly the problem with pension funds is larger than had been realised when the programme begun.
The Institute for Fiscal Studies (IFS), a well-respected think tank that examines public spending, believes the government will need to announce around £60bn of tax increases or spending cuts to calm the markets. This will require a U-turn of magnificent proportions, by a rookie Prime Minister and Chancellor of the Exchequer, that will cost them dearly what little political capital they still have amongst their supporters.
Instead, a modest new tax on energy companies has been announced. And the Chancellor has promised to bring forward a financial statement to the end of October, which will outline how he will bring down the budget deficit over the medium term and will come with commentary from the independent Office of Budget Responsibility (OBR).
The Bank has suggested it may extend the scheme beyond Friday, but it then backtracked – adding to confusion. It is (currently) adamant that the programme ends on Friday. Long dated-gilt yields are now close to the peaks reached during the post-budget sell-off in late September.
From Friday onwards, the gilt market will have no buyer-of-last-resort. If investors have not heard by then of a government plan for reigning in the deficit, and so joining in the Bank’s battle against inflation rather than working against it, another bout of selling of gilts is likely.
This would create further pain for pension funds, who are caught in the middle of this game of chicken between the central bank and the government.
We have seen in recent weeks that problems on the gilt market feed through onto the Treasury and other government markets. What is the link?
Investors are scenting that a government that is at odds with the central banks may not be just a U.K. problem. The ECB last week warned that eurozone inflation risks becoming embedded, on account of energy subsidies and other fiscal measures aimed at reducing the impact on real incomes of high inflation.
In the U.S. President Biden has spoken in favour of the Fed’s aggressive stance on inflation and is prepared to watch the dollar strengthen (often Washington supports business’ calls for weak dollar).
But large spending packages, and industrial policies that roll-back globalisation, will support domestic demand at a time when the Fed is trying to weaken the economy and so create slack in the labour market.
Furthermore, all of these policies have to be paid for, which brings us back to the risk of over-supply of the government bond market.
Investors should avoid a knee-jerk response
Investors are right to be nervous, given the uncertain outlook for the global economy and financial markets. But that very uncertainty suggests caution when adjusting a portfolio.
We may, for example, see core inflation roll over quite quickly if rising interest rates and bond yields lead to a jump in unemployment and weakness in housing markets.
This scenario might suggest buying bonds over the coming months, as yields peak. Then moving into equities, as a new economic cycle begins.
But an alternative scenario is equally possible. Central banks- and bond markets- might continue to have to play catch-up with a more stubborn core inflation problem than anyone had expected. This would lead to further sell-offs of bonds, perhaps revealing more distressed lending with unforeseen consequences for the global financial system.
Defensive currencies, such as the dollar and Swiss franc, and real assets such as gold, may be the only refuge as bonds and equities sell off once again.
Given the diversity of scenarios, a well-balanced portfolio should remain just that: balanced, with no big bets.
- No Investment Advice: This financial commentary is for informational purposes only and is not intended to be, and should not be, construed as an offer to sell or a solicitation of an offer to buy any security or financial instrument or invest in any equity or investment strategy. It should not be used to form the basis of any investment decision.
- Investment Risks: There are risks associated with investing in securities and past performance is not indicative of future results. Always seek professional advice before investing.
- Not Legal/Tax Advice: This financial commentary is not intended to be, and should not be construed as, legal, regulatory, tax, or accounting advice. Always seek professional advice and consult with your legal counsel, tax and accounting advisors when contemplating any course of action.