1st Oct '22 by Edmund Shing

12 comments 2905 reads

Market Musings 011022:
Time for a UK countertrend rally

We enter October with conditions ripe for at least a decent stock market rally

This week’s podcast:

We answer your questions

This report aims to answer our clients’ most frequently asked questions of the moment

Summary:

UK chaos leads to investing opportunities in bonds, stocks
Bank of England expected by interest rate markets to continue raising the base rate to 5.6% by March 2023
Expect pain in the UK residential housing market as mortgage rates soar
Investment opportunities in US-dollar earners, dividend-payers in the FTSE

UK chaos creates an opportunity

As if the ongoing bear market in financial markets wasn’t already generating enough volatility, the UK Conservative government had to add more excitement of their own from a remarkably eventful tax-cutting mini-budget.

I am not going to discuss the ins and outs of these tax-cutting measures, save to say that I personally found some of the tax cuts unveiled.an inefficient way to potentially boost the economy.

What is more interesting to me is the reaction of financial markets, which was initially very negative - reflected in the plunge in the value of sterling against the US dollar, and in the sharp spike in the long-term UK gilt (government bond) yield.

Mini-budget unleashes huge moves in sterling, UK bond yields

Source:Bloomberg

The 30-year UK gilt yield has risen from under 2.3% in early August to peak at 5% post-budget, less than two months later. It was this unprecedented move higher in bond yields and the subsequent threat of insolvency of UK final salary pension funds (for further explanation of this risk, see this article) that then forced the Bank of England to step in to stabilise the bond market with an emergency bond buying program.

"Were dysfunction in this market to continue or worsen, there would be a material risk to UK financial stability,"

the BoE warned.

As a result, both sterling and UK gilts have retraced some of their post-budget panic reaction, with the 30-year gilt yield retreating to 3.8% and sterling recovering to $1.12 (EUR1.14).

37-year low for sterling v US dollar, highest 30-year gilt yield since 2009

Source: Bloomberg

The UK is not at all out of the woods yet. The Bank of England is certain to raise its base interest rate…

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Norfolk'n'Good

1st Oct '22

Hi Edmund

Is the rush by the Bank of England to increase base rate more to shore up sterling in reality, than it is to cool inflation? My vague memory of economics tells me that base rate rises can take many months to have any effect on the economy.

Breakout Trader

excellent article and podcast Edmund, thank you.

I’m sure Edmund will give a much better answer, but I’m going to chime in here with how I understand it.

The fall in Sterling is reflecting decreased confidence in the uk’s ability to reduce inflation, stabilise the economy and move back to growth.

To deal with inflation effectively, the government and central bank should implement policies which are politically unpopular, I.e. on the fiscal (government) side: higher taxes and lower spending, and on the monetary (central bank) side: lower money supply (quantitative tightening) and higher interest rates.

The “fiscal event” showed that government are loosening their fiscal policy, as truss and kwarteng believe controlling inflation is the BoE’s responsibility. This lack of coherence between fiscal policy and monetary policy is causing the markets to lose confidence in the uk economy and sterling.

Raising interest rates by a higher amount should in the short term increase confidence, by signalling to investors that the BoE is acting to mitigate the fiscal policies of the government. Medium to long term higher rates should help manage inflation by encouraging saving over spending, and increasing borrowing costs which will reduce output of goods and services.

Edmund Shing

2nd Oct '22

Hi there

Yes in principle, you are right, there is typically a lag of 12+ months between a rise in central bank interest rate and effect on slowing the economy, and by extension of inflation pressures.

However in this case, remember that the UK imports a lot of goods from abroad - for instance, 2/3rds of the food in the UK is imported. In this case, a weak currency has a direct impact on raising the cost of importing goods, as those goods are bought typically in euros or US dollars.

So in this specific case, raising interest rates to support sterling can have a pretty quick effect on capping imported goods inflation, at least.

But for other sources of inflation like house prices/rents and employment/salaries, you are right, it will take time… That said, as I wrote above, I believe that the impact on the housing market will be pretty fast given the scale of the interest rate rises and the huge sensitivity of the economy, and of households in particular, to the cost of financing given high levels of debt.

Of course, this higher cost of mortgages risks arriving at the same time as higher energy bills, so potentially a double-whammy for a mortgaged homeowning household.

Edmund

Ok, so far so good Edmund and thanks BT for your input. BUT isn't one definition of inflation 'too much money chasing too few goods' ?

Since 2009 both the Fed and B of E have been pumping money into the respective economies (QE) and yet we have, for the most part, enjoyed record low interest rates during this period and record low inflation.

To my naive (but willing to be educated!) economic brain this simply doesn't make sense. It suggests to me that something else is driving inflation. Could this be supply side (closing, then re-opening economies, broken supply chains, rapidly rising shipping costs, stock piling etc) inflation we are witnessing post covid, rather than demand side? And if so, wouldn't it have worked through without intervention? Clearly the whole picture has been muddied by the dreadful events in Ukraine.

I'm guessing also that the US Dollar as a 'safe haven' has been strengthening against all currencies as world markets panic, which in turn hasn't helped Sterling or the Euro?

Not actually sure where I'm going with this ramble but I'm keen to try and learn about economics without stumping up for a degree!

Covid certainly produced the perfect cocktail for trouble - sky high public spending as productivity fell off a cliff. Inflation is the inevitable result, even though - and this is an objective observation, not political - at the time many were demanding even more spending and support from governments.

I'll let Edmund educate us both further.

The Phoenix

From 2009 to March 2020 most of the QE done ended up in assets and didn't filter through to the wider economic system, covid required money to be given directly to the public, services like pubs were closed down, so money chased goods, inflation started emerging Jan 2021 and Russian invasion put rocket fuel under it.

Any thoughts on asset allocation in current environment Edmund for example is it to late to in the day buy an ETF that tracks the dollar ?

Regards Andy

JCAS

thanks Edmund, I really enjoy these posts. Are there any UK focussed investment trusts (or tracker/ETF) that you/readers would look at for further research?

Epitychia

3rd Oct '22

yes, maybe 12 month delay. This is why Bailey of the BOE needs the sack. The current interest rate in no way is putting a brake on inflation. We should have started a year ago and be at 6 percent now. In which case inflation would be declining. Personally I think it is now too late, it is entrenched. Which means only a mayor recession will kill it.

chelsea

It's worth noting that most of the import inflationary pressures are from the strong USD. Oil being a prime example. However EUR/GBP is trading in the middle of its 5 year average eyeballing the attached chart. .8700 or 1.15 if you prefer so the pressure from European imports should be considerably less or at least not currency related.

https://www.tradingview.com/sy...

Chris Brown

I agree we could be due a short-term bounce. Sentiment is at all-time lows by all accounts. The drivers of this bear market have been the surging US dollar and higher government bond yields. Both are showing signs of at least a short-term top, last week.

There is the potential for headline year-on-year inflation numbers to begin moderating in the next few months. This is month-on-month US CPI, below. The September release is on October 13, when we'll drop the 0.4% from September 2021. Then, from the October release on 10 November, we'll begin to drop the big numbers... 0.9% from October 2021.

If current month-on-month figures remain relatively stable (like July/Aug 22) then the headline rate could be way down to say 3% by April.

The UK month-on-month rates are still quite high (0.5% for August) so the decline may be slower this side of the pond. However, if inflation does generally decline more quickly than expected, then that may create a significant change in the market narrative. The equity market will bottom when both inflation concerns and restrictive central bank policy are in the rear-view mirror.

Market Musings 011022: Time for a UK countertrend rally

Market Musings 011022:
Time for a UK countertrend rally

This week’s podcast:

We answer your questions

Summary:

UK chaos creates an opportunity

"Were dysfunction in this market to continue or worsen, there would be a material risk to UK financial stability,"

Unlock the rest of this article with a 14 day trial

About the Author

Edmund Shing

12 comments

Unlock the metrics for all these stocks and more...

Unlock the metrics for all these stocks and more...

Market Musings 011022: Time for a UK countertrend rally

Market Musings 011022:Time for a UK countertrend rally

This week’s podcast:

We answer your questions

Summary:

UK chaos creates an opportunity

"Were dysfunction in this market to continue or worsen, there would be a material risk to UK financial stability,"

Unlock the rest of this article with a 14 day trial

About the Author

Edmund Shing

12 comments

Unlock the metrics for all these stocks and more...

Unlock the metrics for all these stocks and more...

Market Musings 011022:
Time for a UK countertrend rally