Multi-asset allocation views

Read this article to understand:

• Why gilts have underperformed other government bonds
• Why UK inflation remains so persistent
• What this means for gilts

Over the last 12 months, in what has been a challenging period for fixed income, the UK has faced particular difficulties, highlighting the importance of a globally diversified portfolio. 

After the shambolic mini-budget last Autumn, the UK has returned to more mainstream and market-friendly economic management. Yet the returns on UK gilts compared to US Treasuries have not improved. Looking at one-year returns, gilts have underperformed US Treasuries by seven per cent and German bunds by about five per cent.

In other words, if an investor had bought gilts at the expense of US Treasuries at the height of the mini-budget crisis, they would barely be better off now. The period from April to early June saw a dramatic sell-off, and what happened can be described as a play in three acts.

Act one: The mini budget

At the time of the mini budget, there was concern about the UK's ability to get a grip on inflation and the risk that eventually the required monetary tightening would cause a recession. But, with independent institutions like the Office for Budget Responsibility (OBR) and the Bank of England being sidelined, UK borrowers also had to pay more because of uncertainty about how well the UK's economic institutional framework was holding up (see Multi-asset allocation views: How politics are influencing markets).¹

In the face of a weakening of the guard rails around UK economic management, international investors can decide not to hold sterling as a currency if they are not sure it will hold its value. They can also demand a higher term premium for bonds, the additional return they need on top of cash interest rates to tie their money up for longer in government bonds.

They did both, but the challenge was short-lived. To give an example, UK ten-year gilts underperformed their US equivalents by about ten per cent from mid-August to mid-October 2022. However, by early November, those losses had been made up.

One of the first priorities for the Sunak/Hunt government was to offer reassurance the institutional framework would not be challenged. That quickly allayed investors’ fears and led to a substantial rally in gilts. 

It also led to a reasonable rally in sterling, to the extent the Bank of England was given the assurance there would be no government pressure on it to change policy and a proposed review of the Bank’s policy framework was scrapped. That provided support for continued rate rises and the pound. 

After a period of looking like a significant outlier, the UK no longer seemed dramatically out of line with other countries that had seen rises in government bond yields and borrowing costs.

Act two: Recession fears

From November to January, global investor concerns shifted to a widespread expectation the UK and Europe would experience a recession last winter because of rising energy prices. 

But thanks to deliberate policies to increase energy sources and storage, as well as a lull in fighting in Ukraine, the biggest cost-of-living fears did not materialise. This allowed Europe to go through only a mild recession and the UK to avoid it altogether.

Act three: Persistent inflation

From February to mid-June 2023, investors continued to expect a slowdown in UK economic activity, this time driven by higher interest rates. As recently as early August 2022, the base rate was 1.25 per cent, rising to 3.5 per cent by the end of the year and to 4.25 per cent by the end of March. 

There was a general assumption the UK is more than averagely exposed to rises in Bank of England base rates because of its large mortgage market, where most householders borrow at either variable or short-term fixed rates. Therefore, markets expected rising interest rates to translate quickly into higher mortgage rates, dampening economic activity. 

But higher rates did not push the UK into a recession. The value of retail sales in the year to December 2022 was just over three per cent, broadly in line with the last five years. Markets expected this to slow sharply in the first quarter of 2023: in fact, it accelerated slightly, which came as a big surprise.

The other surprise was that monetary policy did not lower inflation either. Markets expected inflation to have dropped to between three and five per cent by July 2023, possibly lower if higher interest rates had led to economic difficulties. Yet year-on-year consumer price index (CPI) inflation had only shifted down to 7.9 per cent in July, from 10.5 per cent at the end of 2022 – and still over ten per cent at the end of March.

In contrast, there is evidence of inflation slowing more convincingly in other economies. US year-on-year inflation peaked in June 2022 at nine per cent and is now at three. Euro area inflation peaked later, at the end of October, at 10.6 per cent but is now 5.5 per cent.²

Why is UK inflation so stubborn? Nature and nurture

This experience puts the spotlight on differences between the UK and its US and European counterparts. Some are due to policy and others to the nature of the UK economy, but all help explain the persistence of UK inflation.

In terms of policy, the UK’s approach to managing energy prices was more volatile than in other countries. Even though continental Europe was facing the same pressures, countries found a way to even them out more for households. In theory, that might mean energy prices start to come down more quickly in the UK, but that is yet to come through. 

A bigger challenge is that the UK is a small, open economy compared to the super-blocs of North America and the euro area. As such, it is likely to import a greater share of purchases and doesn't always have much control over the prices companies charge for those imports. Therefore, even though sterling has strengthened as UK interest rate rises have continued, it has not led to meaningful declines in imported prices.

Following post-financial-crisis austerity, there has also been a stronger sense in the UK’s political debate that workers were “overdue” a pay rise, and wage increases would have to make up for this beyond just keeping pace with inflation. As a result, recent wage acceleration has not been responsive to changes in the Bank of England’s base rate or government policy. In June 2022, year-on-year wage growth was 4.7 per cent; by December it was up to 6.7 per cent.

In addition, a Bloomberg Economics analysis recently showed that while households have been paying billions of pounds more in mortgages than before the rate hikes, banks have been paying out even larger amounts in extra interest on savings accounts. It would be naïve to see higher rates as stimulating more spending, given interest income does not tend to generate much consumption while mortgage payments can cut disposable income sharply. Nevertheless, with higher savings rates available and fewer people with mortgages than in previous years, rate rises are less effective at dampening growth and inflation.³

This left investors and economists wondering whether the UK’s famous sensitivity to interest rates might have weakened. The thought inflation expectations might have become unanchored from rate rises, or the structure of the economy might stop rate rises from bringing inflation down, was a contributor to the dramatic sell off we saw from April to June (see Figure 1).

All this has led the Bank of England to review its forecasts on how high interest rates would have to go. In early July, markets were expecting rates to reach 6.5 per cent by March 2024.⁴

Next act: Unsustainably high?

However, we don't think this is going to continue. 

Firstly, there is a growing sense such high interest rates may finally be enough to start putting brakes on the economy. And because no one can see an immediate catalyst that could reduce rates in the same way as happened after the mini budget, they may well propagate across a wider range of rates – into mortgage rates, corporate bond markets and the interest paid on savings. Borrowers may not be able to escape higher resets by putting off refinancing for a few months.

That suggests such levels may be unsustainable because of the real economic impact they have – and markets are starting to react. June’s CPI report, and the Bank of England meeting the following day, both surprised investors in the direction of higher inflation and interest rates. However, two key markets showed a surprising response.

Firstly, these hawkish surprises should have led sterling to strengthen. In general, the currency has this year followed a textbook response whereby higher UK deposit rates increase the attractiveness of holding sterling. In the event, sterling weakened slightly against most major currencies, suggesting investors were starting to worry more seriously about the sustainability of interest rates the UK is delivering in the near term.

Secondly, gilts bucked the trend of previous months. This year, positive surprises in short-term rates have led yields to increase essentially in parallel at all maturities – in contrast to overseas peers, where longer-dated yields have generally smoothed out short-dated volatility. One could see this as evidence of investors giving up on traditional ideas of self-stabilising forces in the UK economy, instead seeing future rates as more of a “random walk”. The June news, however, saw a distinct flattening move in the term structure (i.e., near-term rates moving much higher than longer-dated ones). This means investors are increasingly seeing the coming months’ projections for rates as unlikely to be maintained, instead heralding a rate-cutting cycle and, in all likelihood, a recession.

Investment implications

We cannot say exactly when rates will peak, as that will depend on future inflation and related data. But relative to other markets, the UK is now closer to the biting point where higher rates cannot necessarily be sustained.

This could force investors to think about the yields being offered on gilts versus cash and instant-access savings accounts. Although the former may not be quite as income-generative as the latter, gilts allow investors to lock-in yields for their duration, whereas cash and instant-access savings rates could go down in lockstep with the Bank of England’s base rate. These are decisions investors will need to consider.

In addition, the gilt market has already priced in a number of upcoming rate rises, meaning their value may not fall much further with the next increase. On the other hand, if higher rates start to bite, gilts offer some form of recession protection, as their value will likely rise if interest rates fall.

From a global portfolio construction perspective, not just in the UK, the inverse relationship between bonds and equities has also improved. While both asset classes were selling off together in 2022, this year, strong equity markets have shown to be weaker times for bonds and vice-versa. Of course, market performance is never guaranteed, but bonds are somewhat rehabilitated as a way to diversify portfolios.

For multi-asset portfolios, after a difficult year, these changing circumstances have improved the outlook for gilts.