Westminster has been “heated up” in recent months and too often events have had dramatic consequences for the markets.
The mini-budget presented by Kwasi Kwarteng was anything but mini in its impact. Essentially, he committed the government to a lot of spending, without any accompanying tax measures to fund it. The markets reacted in horror, the Conservative Party seemed to go into panic mode and the rest, as they say, is history.
Many mini-budget measures have now been rolled back and even utility bill assistance is being reviewed for the period beyond early spring. So, will there be lasting consequences of the turmoil of recent months? Let’s take a look at what really happened and where the markets are today.
Sound like a pound?
Much has been made of the collapse in the value of the pound that occurred after the mini-budget. The pound indeed fell quickly in the aftermath, but it quickly recovered. The pound is now worth more than it was before the unfortunate chancellor rose to present his mini-budget.
The dollar against the pound from the date of the mini-budget
Source: Bank of England, as of November 8, 2022.
Currency markets were deeply impressed at first. During Asian trading hours on the Monday following the mini-budget, the pound fell to just $1.04, before rebounding rapidly.
Now that the spending plans have been reversed, there is a more conservative, small “c” approach to making spending commitments to the treasury. Confidence in the value of the pound has improved accordingly.
The UK import bill is no longer rising due to the weak pound. However, given that about a year ago a pound would have bought you more than $1.40, that’s still much higher than it was. This has a direct impact on the cost of energy and foreign-made goods. This puts pressure on household incomes and corporate profit margins unless they can increase profits or sales prices respectively.
Interest rates and bond yields
The cost of a new mortgage is now much higher than it was before the mini-budget. The cost of two-year fixed-rate mortgages has more than doubled over the past year, with much of the increase occurring in the weeks following the mini-budget.
Rates were already on the rise, pushed higher by inflation and the Bank of England raising the base interest rate seven times already this year. Lenders are increasingly anticipating future increases and building them into their rates, leaving fixed rates well above the current base rate.
This is clearly troubling for borrowers and businesses. The effect is not yet widely felt. Indeed, people and companies benefiting from fixed tariffs will not see any increase until the end of their tariff agreement. There will be a continuing wave of discomfort as borrowings are re-priced to new levels.
The other side of the borrower’s pain is the savers’ pleasure. For the past ten years, yields on bank deposits have been very low. Now savers, if they shop around, can find far more attractive rates.
Shop with Active Savings
There were chaotic scenes in the bond market after the mini-budget. Strong price fluctuations have forced pension funds to provide more collateral against hedging contracts. This has led funds to become forced sellers of the very bonds they rely on to provide greater certainty of long-term returns.
They weren’t going to go bankrupt, as rising yields had reduced their liabilities, but tighter liquidity forced the BoE to step in as a buyer of last resort to restore order to the market. Yields have now returned to levels close to where they were before Kwasi Kwarteng rose. But they are still several percent higher than they were at the start of the year.
What can investors do?
With the future looking even more uncertain than ever, diversification should be investors’ first thought. The world is moving away from an era of ultra-low interest rates, a decade or so in which asset prices rose steadily. The inflation that has appeared threatens to upset all that.
Deflation, not inflation, was seen as a more likely future, and billions of dollars in bonds offered negative forward-looking returns. Companies had raised funds at insignificant interest rates. Not anymore. US government debt yields rose 4% and corporate borrowing costs nearly doubled to just under 6%, according to ratings agency Moody’s.
Times will be tougher for many over the next two years until inflation is brought under control and interest rates stabilize. There is no guarantee, and perhaps no likelihood, that they will settle at levels below today’s rates unless inflation really kicks in.
Businesses will need to have secure revenue and good cost management skills to thrive in the coming quarters. The United Kingdom does not have a specific “refuge” status. Our reliance on relatively short fixed terms for mortgages means we could feel the impact of rising rates harder and sooner. International diversification can spread this risk.
The company’s profits are set for a squeeze. Governments want more taxes, costs are rising and corporate debt financing is becoming more expensive. And that’s before the trade suffered from the tougher economic conditions. The defense looks attractive right now – lackluster and dependable has never looked so appealing. Any asset whose value depends on the availability of abundant and cheap financing should be treated with great caution.
After years of deeming bonds too expensive, I’m not sure this case is that solid anymore. The forward-looking return of almost 6% announced by Moody’s is interesting, if inflation ebbs while rates bite. This is the highest level I have seen for corporate bonds in over a decade to date.
Corporate bonds are not without risk, however. Businesses can default if they are going through tough times. They may be exposed to high risk high yield bonds and ultimately there is no guarantee, so you could suffer a loss. Remember that returns are variable and are not a reliable indicator of future income.
We cannot wish for hard times. But if we focus on quality and defensiveness, diversifying portfolios across the world and across different asset types, we can help portfolios weather the storm. Over the long term, investing in the markets has proven to be a way to generate longer-term wealth.
This article is not personal advice. If you are unsure of an investment for your situation, seek financial advice. All investments and any income they produce can fall or rise in value, so you may get back less than you invest. Past performance is not indicative of the future.
Steve Clayton is fund manager of the HL Select family of funds. HL Select funds are managed by our sister company Hargreaves Lansdown Fund Managers Ltd.