UK Assets: taking stock

5 min read 26 Oct 22

Events continue to move at speed in UK politics. With a new UK Prime Minister named (again!) we’re hopeful that volatility will reduce in UK bond and equity markets.  Even before Rishi Sunak took office, two-thirds of the unfunded tax cuts set out in the Mini-Budget of September 23rd had been reversed.

In this article, we explain our current views on UK Government Bonds and UK equities. We don’t own UK government bonds in our model portfolios and we have a neutral view on UK equities.

UK Government Bonds

The yield on a 30-year UK government bonds (gilts) rose from 1% at the start of 2022 to a peak of 5% and has since declined to 3.7% (at time of writing). There is an inverse relationship between prices and yields, which means that a 30-year gilt bought at the start of 2022 is now worth 40% less in capital terms. The other side of this equation means that new buyers can earn attractive yields.

Reversing part of the Mini-Budget proposals has restored some calm to UK markets. Another government budget update is planned for 31 October. More restrictive fiscal policies should take pressure off the Bank of England (BoE) to rapidly increase interest rates. That’s because tighter fiscal policy is less inflationary. Bank of England Deputy Governor Ben Broadbent evidenced this point in a speech last week saying he didn’t think rates would go as high as the market is predicting [i].

Yields on UK Government Bonds have fallen significantly from their post-Mini-Budget highs. We think two key factors will prevent UK bond yields falling much lower:

  1. UK inflation continues to rise and at a pace exceeding expectations [ii]. With sterling remaining weak, this will ‘import’ more inflation (via food and energy costs) and prevent the BoE from reducing interest rates.
  2. The supply of gilts is forecasted to rise at the same time as the BoE plans to sell some of the government debt it has bought over the last decade. Based on projections from the Debt Management Office (DMO) the amount of debt the UK issues in the 2023/24 fiscal year will reach a record level [iii]. From March 2009 (when the BoE first began quantitative easing), the DMO has sold a net £1.5 trillion of Gilts. Of this circa 57% was bought by the BoE, 37% by overseas investors and only 6% by domestic investors [iv]. We think the high level of supply of UK bonds and the lack of purchases by the BoE will keep yields from falling significantly.

UK Equities

UK equities have been resilient in 2022, outperforming global equities in local currency terms. There are positives and negatives in the current outlook. Roughly 80% of revenues for companies in the FTSE 100 Index are generated overseas. This means the market is not closely linked to the UK economy.  We think UK large cap stocks will benefit from the weaker currency and domestic investors seeking companies that can provide greater certainty over earnings. The UK market also has several large energy and commodity companies. These sectors have performed well over the past year, however if there is a global recession demand in these areas would fall. Domestically focussed UK names are vulnerable to the slowing UK economy and the pressures on UK consumers.  Also, international investors may be reluctant to put money into UK markets when the outlook for sterling is uncertain. In short, we think the positives and negatives are well-balanced.

Overall

International equities and bonds make up most of our model portfolios. This makes the portfolios diversified and gives our clients protection when certain countries or regions experience volatility. While there are some reasons to be more optimistic about UK bonds and equities, we are not increasing exposure.

We think inflationary pressures and the large supply of UK bonds in the market over the next two years will prevent a sharp fall in UK government bond yields. More restrictive fiscal policy could mean interest rates peak at a lower level.  We think sterling will remain under pressure. There are also factors outside the UK’s control, particularly the uncertainty around energy prices and the global economic outlook.

 

[i] https://www.bankofengland.co.uk/speech/2022/october/ben-broadbent-speech-at-imperial-college-the-inflationary-consequences-of-real-shocks
[ii] UK CPI rose to 10.1% in September higher than economists’ expectations.
[iii] An updated fiscal statement with full OBR costings is forecast for 31 October (subject to the new PMs approval)
[iv] BofA Global Research, August 2022