Is this the eye of the storm?
As a hurricane races across the countryside, there can be a calm period before the winds pick up again. Such is the situation facing the Chancellor, Jeremy Hunt, as he prepares for his Autumn Statement, now delayed until 17th November. He will look gratefully at the recent improvements in borrowing costs for the UK Government. Indeed the benchmark gilt yield has declined to levels seen just before the ill- fated Kwarteng/Truss fiscal announcements, helped by expectations about a lower peak in interest rates amongst our major trading partners. Nevertheless, the Chancellor faces a series of difficult decisions, against the backdrop of a continued risk premium needed to encourage overseas investors to buy and hold UK assets.
UK gilt yields have fallen back sharply from their recent peaks, with the 10 year yield back towards 3.55%, helped by signs of more orthodox thinking about tax, spending, borrowing and growth. There were tremors at the possibility that Boris Johnson might become Prime Minister, then reassurance that the vast majority of the proposals from Liz Truss were quickly being undone by Sunak and Hunt. All eyes are now on 17th November to see how extensive the fiscal reassessment will be.
Of course, many questions await answers. Can a divided Parliament push through sufficient tax increases and spending cuts to enable the Office for Budget Responsibility to confirm that public sector borrowing is under control and debt can decline as a percentage of GDP over time? Can debt servicing be brought back under control? One third of the public sector’s borrowing in the month of September was to service existing debt. One quarter of national debt is inflation linked, hence another surge in energy prices this winter would be painful. Lastly, there is little that the government can do quickly about the structural pressures facing the economy. On some estimates, the UK’s potential growth rate has shrunk to about 1.5% a year from 2.5% before the 2008 crisis.
The downward move in gilt yields has been assisted by a decline of about 0.25% in European and US benchmark bond yields over the past week. One reason was the growing evidence of weak growth or even recessionary conditions in all the major economies. The much publicised purchasing manager indices have generally fallen to levels which signal a contraction in global manufacturing, not helped by continued Covid curbs in China. Mortgage rates above 7% in the USA are bearing down on the housing market, whilst jobless claims are starting to rise as consumers slowly pull back on spending. The backdrop to the Autumn Statement in the UK appears particularly bleak. For example, figures from EY-Parthenon showed profit warnings at UK listed companies in the third quarter at their highest since 2008. A survey by the accountant BDO found that a fifth of medium-sized companies believe the present crisis will be more challenging than the Covid pandemic, Brexit or the 2008 crash. Other surveys by Deloitte showed that consumer confidence has dropped to the lowest level since records began in 2011, whilst firms reported a marked drop in hiring expectations.
Alongside this news about weaker growth, there has been a welcome decline in natural gas prices as mild autumn weather and continued strong LNG imports has enabled a further improvement in gas storage. As a result, there has been a reassessment of how high interest rates need to move in coming months. Although Philadelphia Federal Reserve President Patrick Harker worried about “our frankly disappointing lack of progress in curtailing inflation”, San Francisco Fed President Mary Daly indicated a preference for smaller hikes. The peak for US rates next May has eased back from 5% towards 4.75%. After the ECB’s decision this week to raise rates by another 0.75%, as had been widely expected, Christine Lagarde indicated that “substantial” progress had been made in the fight against inflation. Hence, the market is now expecting only another 0.5% move in December and 0.25% next spring, after which the central bank can assess the efficacy of its actions.
As some calm descends on UK bond markets, the Chancellor has to face the reality that the political ructions of recent weeks have resulted in a risk premium priced into UK assets, dubbed by some the Fiscal Fiasco Factor. The difference in yields between 10 year UK gilts and 10 year German bonds has averaged about 1% over the past 5 years. It currently stands about 1.5%. Overseas investors will look for solid evidence in the Autumn Statement that fiscal conservatism is strongly embedded, as otherwise the storm surrounding UK financial markets could pick up again remarkably quickly.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.37 4.12 3.96
UK 3.21 3.61 3.56
Germany 1.80 1.86 2.02
Andrew Milligan is an independent economist and investment consultant. This note is offered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making