Higher inflation trumps Reeves reforms

Hello, it's Thursday, the 17th of July. A lot has been going on this week already, whether it be the Mansion House speech, the lease reforms, the inflation print in the UK and indeed unemployment and movements that these have caused in the market. So we're going to stick at home this week and really focus on the impact on the gilt market of that inflation print, because as much as there was lots of news out there, the really impactful one from a market perspective was the CPI data which came out on Wednesday.

It was really a week where the government and perhaps most importantly the chancellor seem to be returning to the front foot having had that bruising encounter with their own MPs over the desire to cut welfare that we saw a couple of weeks ago. We have overall a picture of sort of reform coming through the Mansion House speech and the lease reforms in particular which seems sort of on the face of it pretty logical and indeed the sorts of things you've heard previous governments talk about in many ways; cutting red tape and bureaucracy, making perhaps business culture a little bit less risk averse and indeed encouraging investment as opposed to pure sort of cash savings as well. So there was lots of positivity in there, but amongst all of this we have this CPI print which came out yesterday and it came in at 3.6 percent compared to expectations of 3.4.

What does this mean?

So it has been a sort of pretty meaningful move back up. And in fact, inflation was only in the twos, it was a 2.6, I think it was back in March this year. So a reasonably meaningful move back up in inflation in the UK over the last few months. The blame for this or the rationale for it has been laid in many different places, partly down to food increases, partly because of the national insurance increase, partly because of increase in minimum wage, and there will be plenty of other factors alongside those main ones, but what it does, of course, is it makes it harder for the Bank of England to cut interest rates. The inflationary pressures is the main way you're trying to manage inflation through the Bank of England base rate policy. So the inflation pressure makes it harder for them to argue in favour of cutting interest rates, despite the fact, perhaps behind the scenes, that the economy is not looking particularly robust and indeed some of that was borne out by the unemployment data that we saw come out today, in fact. So overall, it's a bit of a mixed picture. The inflation is the fly in the ointment that perhaps all else being equal, you'd expect to see interest rates coming down quicker. But ultimately, the Bank of England's main focus, sole focus really, is on keeping inflation back to that target of 2%. And the main way that you would expect in a traditional monetary policy sense to get inflation back down is by keeping interest rates where they are, or perhaps even increasing them, which would seemingly swim against the tide of the need for loosening some of these other measures out there.

It is a complicated environment for central bankers to navigate as it has been often in the last few years. It seems as though the August interest rate cut is broadly expected, but the overall market pricing for interest rate cuts in the UK for the rest of the year is now 43 basis points, so it's just below what would normally be perceived to be two cuts of 25 basis points each at 50 basis points. So it's somewhere between one and two, which is closer to two still being priced in, but we were essentially fully pricing in two interest rate cuts this year before that CPI data came out.

What is the impact?

The main move in terms of markets over this week has been an increase in gilt yields back up to the 10-year, back up 4.66%, last time I looked. And that yield has moved around a fair amount year-to-date. 4.6, 4.7 is amongst the higher levels that we've seen in peaks throughout the course of the year. In January, we were in the 4.9 territory, if you round it up a little bit. So it is down from the highs at the start of the year, but it is amongst the higher levels that we've seen over the course of the year. And the point from investment perspective, as you know, is the price of gilts is inversely related to the yield that you can receive for those gilts. So if the yield goes up, the price comes down. We don't want to overdo it though in the sense of a move in a handful of basis points, it's not going to have a dramatic impact in terms of the price of these instruments, but in fixed income land, such are the fine margins of returns and such is the finesse with which you can model these things, you can often find a real focus on relatively small moves. In the grand scheme of things, it is not massive, but it has led to gilts underperforming other developed market peers such as European bonds over the course of the week because the impact of the inflationary number in the UK has been a UK specific phenomenon and so we've seen yields increase in the UK rather than a more broad brush approach to interest rates increasing in government bond markets.

How does this fit with our current tactical asset location?

So overall, the impact in terms of our TAA will be a modest one over the course of the week. We actually have gilts as a 3 out of 5 in our scoring methodology. We think these sorts of prevailing yields, the 4.5s and 4.6s, for example, are pretty attractive and they do give you a real yield in the sense of that prevailing interest rate you're getting from that 10-year bond is higher than even the higher rates of inflation that we've seen come through this week. So you're getting a meaningful real yield from that asset class. We do believe it's attractive. We do diversify that gilt allocation or the fixed income allocation, outside of gilts. We have global government bonds which have different interest rate curves and different interest rates sensitivities. We also have other investments in other parts of the fixed income market, such as credit; we've got global credit, UK investment grade credit and also high yield investments as well. That's less of a generally robust diversifier in the portfolios. It is a bit higher in the risk curve, if you like, but it is still a fixed income cohort of instruments. And so it does provide a fixed-income role. Also in gilts, we have the short duration allocation, which is generally lower tenor debt. It tends to be less sensitive to interest rate moves. So you've got a lot of diversification even within that fixed income bucket. And then the other point to think about, of course, is the purpose of fixed income generally is there to provide diversity to the equity portion of portfolios. The equity is really the long-term returns drivers in the portfolios and the gilts and other fixed income instruments are there really to sort of provide ballast and diversification.

So if gilts have sold off a little bit over the course of the week, how have equity markets done? Generally speaking, equity markets are still in pretty solid shape. The UK stock market, the FTSE, went through the 9,000 all-time high over the course of the week. It's a little bit off there as we speak today, but it's still touching all-time highs. And then year-to-date, the performance of the UK stock market has actually been pretty good. In local currency terms, it's ahead of Europe, it is ahead of the US year to date. If you translate the European and the US return back into sterling, Europe actually gets its nose ahead because of the strength of the euro versus sterling over that period. But conversely, if you translate the US stock market's return into sterlling, you get a headwind come through from dollar weakness, and so actually the US falls further back. So overall, the UK stock market is offering up decent year-to-date returns for investors and, as you know, we've got a decent allocation to the UK in our Multi-Asset Funds and portfolios. But again, all of this really is a good reminder to over the short term, asset classes move around and having a diverse range of different returns drivers in the portfolios and the Funds is a great way to reduce your sensitivity to any one particular risk factor out there.

That's it from me. Have a great weekend when you get there and we'll see you next time.