Multi-asset allocation views

Read this article to understand:

• Which factors will impact UK markets in the coming months
• What Xi’s tightening grip on power means for economic decoupling
• How the US mid-terms might impact the Treasury market

Throughout 2022, and long after it dominated the headlines, the Russia-Ukraine war has continued to impact economies and markets. Energy prices, sanctions, economic decoupling, the cost-of-living crisis and galloping inflation have all stemmed from the conflict, reminding us just how much politics can impact financial markets.

More recently, investors have been taken aback by the UK’s short-lived “mini budget” and Xi Jinping’s tightening grip on power in China,¹ while following the US mid-term elections.² Markets cannot ignore politics, but to what extent will those events affect valuations?

United Kingdom: The government is unlikely to test markets anytime soon

When the mini budget was announced, bond yields rose dramatically and sterling plunged. Despite the influence of global factors, it is hard to see how domestic politics did not play a part in the market rollercoaster.^3,4

The numbers were not far from expectations, in terms of borrowing plans, tax cuts and the capping of household energy prices. The surprise was that the government took for granted investors and independent experts.

Firstly, the deliberate refusal to discuss how some of these giveaways would be funded suggested borrowing was a feature, not a bug, of the plan. At a time when global bond investors were already thinking harder about whether they were being sufficiently rewarded, the reaction to the mini budget could be seen as a warning not to assume international investors would be indiscriminately willing funders of the UK.

Others who appeared to be side-lined were the independent bodies supposed to provide guardrails for macroeconomic policy: the Office for Budget Responsibility, whose offer of analysis of the mini budget was rejected; and the Bank of England which, since the leadership election in the summer, had the prospect of a government-instructed mandate review hanging over it. This came in addition to the immediate sacking of the Treasury’s top civil servant as soon as Kwasi Kwarteng took office.^5,6,7

A good example of the extent to which confidence declined is the 2068 index-linked bond. At the start of 2022, its price was £290; at the time of the mini budget it troughed at £43. This is not the sort of decline or volatility of capital values investors expect from supposedly safe-haven assets. The move in the real yield on the bond moved from -2 to +2 before stabilising at zero, but that doesn't do justice to the gut-wrenching nature of the capital volatility.⁸

Figure 1: 2068 maturity index-linked bond price, 2022 (GBP)

Source: Bloomberg. Data as of November 10, 2022

Undoubtedly, those moves were exacerbated by domestic factors: UK markets faced the challenges of rapid leverage reduction by liability-driven investors (LDI). But it would be naive to assume forced selling is purely a function of LDI or something we will only see in the UK.⁹

The reality is, when an investor takes on leveraged fixed-income investments, periods of volatility that are bigger than what was stress-tested for will lead to bigger collateral calls than what was budgeted for. If the source of collateral is the same asset that is declining in value, it creates a self-reinforcing spiral. We expect more of these episodes in the fixed-income world.

At the same time, sharp falls in sterling could be partly ascribed to the global theme of dollar strength.¹⁰ But again, international investors are specifically raising the question of being invested in the UK when there are better opportunities elsewhere. This challenge has been laid down not just in bond and currency markets, but equities too.¹¹

So, where does this leave the UK?

The government has been given a sharp reminder it’s a good idea to maintain relations with people who lend you money. That is unlikely to go unheeded. As such, we don't see a material risk UK fiscal incontinence becomes a major source of rising yields from here; meanwhile, LDI investors have had time to raise short-term collateral and improve their stress testing. This means the path ahead for the gilt market is likely to be more in line with the global picture, rather than being an outlier. For that reason, we don't particularly have positions in gilts today.

We do have positions in sterling. Despite a degree of normality returning in the gilt market, the UK is now paying a bigger risk premium, and that is likely to come down only slowly, if at all (Figure 2). It has also placed more pressure on the Bank of England because the inflationary effect of a weaker currency will force it to keep rates higher than it might otherwise have done.

Figure 2: Sterling’s challenges go beyond the mini-budget, 2022

Source: Bloomberg. Data as of November 10, 2022

As we look at the need for material fiscal consolidation, higher interest rates, tax rises, spending cuts and increased uncertainty will limit the UK's potential growth over the next 12 to 24 months, and likely push the UK into a more drawn-out recession.¹² This will restrict how far rates can rise, creating a challenging backdrop for the currency.

In our UK multi-asset portfolios, we want access to a diversified range of international currencies strategically. Tactically, we also think the strength of the dollar is not yet past for sterling investors.

On the bright side, UK companies – particularly large cap – have benefitted from sterling weakness. The FTSE 100 continues to be heavily dominated by international revenues which, when converted into a weak currency, tend to support earnings at a generally difficult time for global companies. That is one reason why the FTSE 100 offers reasonable value and why we favour it in our portfolios.

As we recently discussed, the UK’s balance between commodity producers and more defensive sectors like healthcare and consumer staples also support its resilience, which we also find attractive. Domestic-facing cyclicals such as consumer retail or banking will face headwinds, but on balance, earnings should prove to be steadier for the index overall than we might see in other countries.¹³

China: Politics push foreign investors down the pecking order

While Xi’s reappointment for a third term was expected, what was more noteworthy was how his grip on power strengthened. Firstly, all the appointments to senior positions in the Chinese Communist Party have gone to candidates with strong personal or ideological connections to Xi, so there is no sign of compromise between factions. Secondly, there is no evidence of any succession plan or alternative power bases emerging. This is now Xi’s party, and country, to control.¹⁴

A second development came in the official statements made during the Congress. There was much more emphasis on inequality and warning shots fired at rich individuals and large private companies. The key policy priorities will be seeking greater equality among individuals, but also rebalancing between the private and state-owned sectors and strengthening the latter.¹⁵

This may be concerning for minority western investors in some of those big corporate names, as it suggests their interests will come quite low down the priority list compared to domestic shareholders or the Chinese government.

It also comes at a time when China is having economic difficulties, as shown by GDP releases well below targets set for 2022, the sharp slowdown in the property market, which doesn't yet appear to have fully stabilised, and slow activity related to the zero-COVID policy.¹⁶ Once it was clear there was no challenge over leadership, investors were hoping for a statement announcing a quick pivot towards economic stimulus, but that has not happened.

Figure 3: China housing floor space completions (year-on-year, per cent) and consumer confidence

Source: Bloomberg. Data as of November 10, 2022

However, it is premature to say there will be no stimulus. A key economic working group will be publishing a more direct economic policy agenda by the end of the year, and we expect more easing there. As we head towards the middle of 2023, we also expect more movement in terms of turning the zero-COVID policy into one of disease management rather than eradication. That will provide some support for China reopening and could have an impact, not just on Chinese risk assets, but also on global sectors like commodities.

The long-term theme western investors and companies need to gauge is whether China’s emphasis on national security will come at the expense of growth. The heightened focus on state-owned enterprises is partly about domestic control, but also national self-sufficiency.

Western investors and companies need to prepare for the possibility of an increasing economic decoupling between the West and China, and a more “muscular” Chinese foreign policy, particularly towards Taiwan.

This decoupling is reinforced by US policy. The CHIPS and Science Act and associated directives are designed to deal a long-term blow to China’s ability to develop an advanced semiconductor industry. This is not the same as Trump wanting to negotiate bigger soybean purchases in exchange for trade tariffs. It is much less transactional and the most comprehensive approach from a western country to significantly hold Chinese competition back, rather than simply withdrawing support.¹⁷

The impact of decoupling will not only be felt by Chinese companies. We have seen weakness throughout the year in semiconductor manufacturers in other countries, but decoupling has made it clearer companies like TSMC or Samsung will be forced to choose sides.

Additionally, the US has extended its reach by applying secondary sanctions to entities that deal with sanctioned Chinese entities, even impacting companies at an upstream level like ASML, a major provider of the equipment required to manufacture semiconductors.¹⁸ The US will not allow China to circumvent the restrictions by accessing US allies in Europe, and it will probably impose more and more choices on its allies in this regard.

US: Mid-terms and markets

The latest mid-term results saw a slim Republican majority in the House of Representatives, and a Democratic win in the Senate. Mid-terms commonly show an anti-incumbency bias in elections, so the Democrats have performed well against that benchmark.¹⁹

However, it will be extremely difficult for any major finance-related programmes to pass in a divided Congress. The profile for Treasury supply will likely be lighter, and the government’s ability to provide fiscal stimulus weaker than if Democrats had retained control of both houses. This might have a knock-on effect on growth expectations, especially if a delayed impact from interest-rate tightening starts to show at the same time.

To date, the major impact of rate tightening has been on housing. That is not a trivial part of the US economy as, in some estimates, upwards of ten million jobs in the US are connected to the sector. The 30-year fixed mortgage rate, now above seven per cent for some loans, can be expected to have a braking effect on the housing market.

That said, for interest-rate rises to have a more meaningful effect on the US economy, we would need to see signs of weakness more broadly, and those are still quite patchy. The Job Openings and Labor Turnover survey, after seeming to show the number of job openings was slowing down, has reaccelerated. It is still hard to find signs of a meaningful slowdown, but were we to see that, the fiscal room for manoeuvre in a divided government is likely to be less.²⁰