Financial Update from Brewin Dolphin - 20 October 2023
The Weekly Round-up
Friday 20 October 2023
In his latest weekly round-up, Guy Foster, our Chief Strategist, discusses the outlook for bonds and the challenges facing the UK economy.
We are nearly two weeks past the horrific Hamas attacks on Israel and the implications for financial markets remain. There were plenty of possible sources of market anxiety already circulating. The economy is in a late stage of the cycle, current estimates suggest limited room for strong growth, and with inflation not yet vanquished, monetary policy remains a headwind rather than a tailwind. In that context, the global economy would likely have relatively low resilience to shocks.
The Middle East plays a pivotal role in global energy supply. Since the attacks, the market has ebbed and flowed on guesses as to the extent to which the conflict might broaden from relatively small regional states without energy resources to larger resource-rich regional actors.
Against this backdrop stocks have struggled. In fact, safe havens have been relatively scarce. The most obvious have been energy assets and, indeed, it has been a relatively good environment for energy shares relative to broader equity markets. The oil price had been easing on declining demand expectations, but has been back in the ascendancy since the attacks.
This has complicated the picture for bonds. Higher oil prices mean higher inflation. How policymakers react to higher energy prices varies depending upon the inflationary regime in place at the time. After the financial crisis, a rapid rebound in energy coincided with a period of relatively weak labour markets. Although inflation was high it was seen as being unsustainable. With low job security, consumers would react to higher energy prices by reducing discretionary spending. With today’s tight labour markets, the concern is that consumers will react by demanding higher wages.
Comments from policymakers have been nuanced. Whilst the tone makes clear that the fight against inflation will continue, the substance of comments has continued to suggest that the Federal Reserve is playing it by ear. The Fed will almost certainly leave rates on hold again in November. It seems likely that the European Central Bank (next Thursday) and the Bank of England will do the same. But despite policymaker restraint, markets continue to belatedly acquiesce to the message that rates will be higher for longer, having spent so long denying that. The yield curve has been gradually becoming less inverted.
Flows data suggests a lot of investors have bought into the bond market as yields have risen. A concern for them will be the heavy supply of new bonds that will be hitting the market over the coming months and years. Conflict has the scope to raise that, as was partly recognised in the news that the ratings agencies, Moody’s and Fitch, have placed Israel’s credit rating on review. Concerns already existed about the weakening of institutions in Israel. Now the prospect of a costly war has raised those concerns further. Israeli bonds are assuming a downgrade is coming. A broader conflict could of course have funding and bond supply implications for other regions as well.
One factor holding back spending in the US is the lack of a functioning House of Representatives. There is little indication of the deadlock among Republicans being broken. Efforts from hardliners to elect Jim Jordan as speaker, and efforts from moderates to expand the powers of the current temporary speaker, both floundered on each other’s resistance.
Returning to the theme of safe havens, gold has served a purpose. Ordinarily the yellow metal reflects concerns about real interest rates and the outlook for the dollar, but the lack of an explicit relationship with bonds can make it a better diversifier at times of inflationary ambiguity.
In the UK, two more by-election losses for the Conservatives make their chances of retaining power after the next general election, at some point in the next year or so, seem even more remote. A recession in an election year would be a further challenge and that seemed progressively more likely with this morning’s retail sales numbers indicating that the UK consumer is retrenching. The weather was certainly a factor as unseasonal warmth during September delayed the need for winter wardrobe refreshes. However, households are cutting back on more than just clothes, so it seems likely that this reflects the eventual impact of interest rates on consumers. An indication of this came in the GfK consumer confidence survey, which fell the most in 13 years and saw a sharp decline in the climate for major purchases, which will be a concern for retailers ahead of Christmas.
Any government seeking re-election will be prone to generosity in the run up to the vote. The UK government faces the twin challenges of persistent inflation and a lack of fiscal headroom. This month’s inflation data was a little underwhelming. Core goods continue to weigh on prices, but are battling against still high core services prices. If households are cutting back on spending as the surveys suggest, then services demand will start to weaken too and the trend will become more explicitly disinflationary. Last year’s utility bill increases in October mean the next report gives prime minister Rishi Sunak a fighting chance of being able to claim he has halved inflation (however opportunistic that claim may be).
In terms of fiscal headroom, there has been some good news. Public borrowing figures have been lower than the Office for Budget Responsibility’s (OBR) forecasts, and the September numbers released this morning were no exception. There will be two more fiscal events before the election: November’s autumn statement and the spring budget. It’s unlikely that we will see any giveaways until closer to the likely election date, as the recent rise in bond yields will likely mean the OBR has to increase its forecast for public spending on interest payments. Given the circumstances of Sunak’s rise to the premiership, as an antidote to the fiscal profligacy of Liz Truss and Kwasi Kwarteng, this is a particularly unfortunate development.
Whether further progress on headline inflation continues will depend upon how successful the global diplomatic effort is at keeping the conflict in the Middle East contained. That, together with the possibility of higher welfare spending during a recession, remain a concern for bond investors.
The value of investments can fall and you may get back less than you invested. Neither simulated nor actual past performance are reliable indicators of future performance. Performance is quoted before charges which will reduce illustrated performance. Investment values may increase or decrease as a result of currency fluctuations. Information is provided only as an example and is not a recommendation to pursue a particular strategy. Information contained in this document is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness. Forecasts are not a reliable indicator of future performance.
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