Monday Espresso Podcast 3rd October 2022

[00:00:00] Sheldon MacDonald: It is the 3rd of October today. We had an action-packed week last week, lots to speak about, and we are joined today by Nathan, by Raj, and also by Danny Fox, who helps run the Marlborough UK bond funds. Lots to speak about, and of course, the key development last week was the mini-budget. Raj, take us through some of the details there.

[00:00:21] Raj Manon: So the key policies were a cut to the basic rate of income tax by 1% to 19%, the removal of the 45% higher rate of income tax, the removal of the planned National insurance and corporation tax increases, and also cuts to stamp duty.

[00:00:41] Sheldon MacDonald: So as their first act, essentially the new government indicating an expansionary fiscal policy right at the time, that until now, monetary policy has been tightening.

[00:00:52] Sheldon MacDonald: The expansionary policy, though that would lead all else being equal to expectations of inflation to be higher for longer, and that then led to higher yields on gilts, which then itself sparked a bit of a gilt crisis.

[00:01:06] Sheldon MacDonald: Danny, can you take us through that?

[00:01:08] Danny Fox: Yeah. I think as the government, struggling with credibility already, and failure to prepare the markets for these moves led to a shift in yields across the UK yield curve substantially higher, and more importantly, extremely quickly.

[00:01:21] Danny Fox: That led to some full selling in the long end of the market from the pension sector, the LDI driven funds having to sell assets to replace collateral on their interest rate swaps, which almost led to a doom loop in the market, which meant the Bank of England had to step in and be the buyer of last resort for those assets.

[00:01:39] Danny Fox: They've committed to buying up to £5 billion of long dated gilts every day for the next 14 days to soothe the market, to give these funds some time to sort out their hedges and their collateral issue.

[00:01:51] Sheldon MacDonald: And that does for the moment at least, seem to have worked, right, so since midweek, since the government did step in, yields have stabilized and in fact rebounded.

[00:02:00] Danny Fox: Yeah, you could make the argument that it's actually worked too well, cuz the long end of the market has actually, yields have fallen back, so the curve has inverted quite substantially, so on the week, the rest of the curve yields are still higher, week on week, but in the long end, yields actually finished lower.

[00:02:17] Sheldon MacDonald: So, so far the government's probably made money on these positions?

[00:02:20] Danny Fox: Yeah, I guess it depends what the level they start buying them at in the next few weeks. .

[00:02:24] Sheldon MacDonald: And of course then the, the other big story of the week though was sterling weakness, again, driven by this lack of confidence.

[00:02:31] Sheldon MacDonald: Sterling getting down to a, a record low, but certainly below £1.05 against the dollar.

[00:02:38] Sheldon MacDonald: Also, since having rebounded. Important, you have to remember though that yes, sterling weakness and there was some particular issues going on in the UK market, but it's not purely a sterling story, it's, it's really one about dollar strength.

[00:02:51] Sheldon MacDonald: We know that other currencies also really struggling against the dollar.

[00:02:55] Sheldon MacDonald: The Euro just going below parity against the dollar a couple of months ago. That was also weak, last week.

[00:03:00] Sheldon MacDonald: Other currencies, the yen has also been struggling for some time now. So dollar strength in this period of uncertainty in this period of volatility. The dollar being the safe haven play and so certainly strength there.

[00:03:13] Sheldon MacDonald: Coming back to the UK though, over the weekend, clearly a lot of developments on the political side, and it seems now that at least the 45p tax rate cut has now been reversed, that though, creating perhaps a further loss of credibility, Danny?

[00:03:29] Danny Fox: Yeah, I think so. The actual size of the difference in, in financial terms that this makes, it's about £2 billion out of about £45 billion of giveaways that were announced, is small, but I think it's more a signal that the government have finally accepted that they need to pay some attention to the markets and worry about how the people that are gonna be buying the bonds, how they treat them going forward, a bit of a return to the days of the bond vigilantes of old.

[00:03:54] Sheldon MacDonald: Yes. An important lesson being learned here that markets will certainly at least give an opinion and perhaps force governments into actions that you know, when the bond markets see them as being patently wrong, they'll force a climb down.

[00:04:06] Sheldon MacDonald: In the meantime, though, some external comment on what's going on, the IMF stepped in.

[00:04:12] Sheldon MacDonald: Very rare that they do so, but stepping in with a criticism of the government's measures and also the ratings agencies taking note.

[00:04:20] Sheldon MacDonald: S&P now formally having put the UK on a negative outlook.

[00:04:25] Sheldon MacDonald: Now if we do get a debt downgrade, obviously that itself then leads to higher borrowing costs and again, you know, difficulties for the market on that front.

[00:04:36] Sheldon MacDonald: So a very tough time in the UK scenario or UK environment at the moment. As I said, though, for the moment, things do seem to have stabilized, and in fact, the FTSE was one of the equity markets at least, that was least impacted last week. We've said before about the fact that the FTSE actually reaps a benefit of a weaker currency.

[00:04:55] Sheldon MacDonald: So perhaps that insulating the market to some extent and also we've spoken about the structural makeup of the FTSE, perhaps also providing a, a bit of a safe haven in the current environment. Of course, though it wasn't all about what's going on in the UK last week, the world is a big place, lots of other issues to confront us.

[00:05:13] Sheldon MacDonald: We had the news last week that European inflation hit a record. Europe as a whole hit 10%. Germany hit 10.9%. And in Germany, again, a, a borrowing package has been announced to provide €200 billion of support for markets there. And then of course, also in the US we had inflation higher than expected, Nathan.

[00:05:36] Nathan Sweeney: Yeah. So I think the good news here is that inflation is obviously lower than Europe, but still lingering. So the preferred measure for the Fed is called the personal consumption expenditure index, or Core PCE, and that number came in a little higher than expected, but it came in at 4.9%. So market's obviously concerned that inflation is lasting longer than it's expected.

[00:05:59] Sheldon MacDonald: And one thing we've not yet seen really to any great degree is the impact of higher inflation and all these higher interest rates on companies.

[00:06:08] Nathan Sweeney: Actually, we're going to get a look through on that pretty soon because we've got company earnings which will kick off not this week, but next week in the US and what we've seen is that companies earnings are being downgraded.

[00:06:21] Nathan Sweeney: So analysts are downgrading these earnings, and that's because of that very point, Sheldon. So you've got higher interest rates, higher inflation, higher cost for companies, which is eating into their profits and we've seen company earnings have been downgraded over the last three months for Q3 for about 6.6%.

[00:06:41] Nathan Sweeney: So you're seeing about 6.6% taken off those earnings expectations. So again, this just one of the big impacts that we're seeing from these increased costs that we're having.

[00:06:50] Sheldon MacDonald: So clearly a, an ongoing difficult environment for companies to try and negotiate. Lots to speak about as I said this week. We've gone over time longer than our normal podcast, so thank you for staying with us and we hope to speak to you again next week.

[00:07:03] Sheldon MacDonald: Thank you.