Lettuces and Prime Ministers (not cabbages and kings)
Voters want more money for public health and education, while public sector workers want higher pay. With just over a year to go before the general election, this is the UK’s political stage. More government borrowing creates a nagging concern for bond investors and clouds the medium-term outlook. Inflation and austerity are potential ways to deal with rising debt levels, neither of which are desirable. Smarter political solutions to rising debt in demographically challenged western nations are required. In the short term though, the focus remains on interest rates. The conditioning to buy bonds takes some shaking and the best hope for a rally relies on confidence that central banks are done with tightening. But there must be questions about how far long-term bond yields can fall and how volatile borrowing costs might be in the years ahead. Bonds are important assets, but the way we view them is changing, relative to the experience of the last 10 years.
This week I had the pleasure of participating in a panel discussion for a financial streaming service. The session was hosted by the British journalist, Robert Peston, and I was joined by two colleagues from other asset managers. The discussion was wide-ranging covering the outlook for central banks; the soft-or-hard landing debate; whether bonds were good value; and the prospects for China to recover enough to have a meaningfully positive impact on global GDP growth in the foreseeable future. There were two other areas though, which I thought were particularly interesting – and on which Peston was very enthusiastic – artificial intelligence (AI) and its likely impact on stocks, and the UK economic and political outlook.
A year on
The one-year anniversary of former UK Prime Minister Liz Truss and Chancellor Kwasi Kwarteng’s failed attempt to shift the direction of fiscal policy in the UK is upon us. The then-Chancellor announced a package of measures in an emergency budget including plans to abolish the 45% top rate of income tax; cut the basic rate from 20% to 19%; reverse a planned increase in corporate taxes; and do away with the bonus cap for bankers. All of this was wrapped up as a “growth plan”. The markets didn’t like it. The yield on benchmark 10-year UK government bonds (gilts) rose from 3.5% on the morning of the mini-budget to 4.5% a few days later. The Bank of England had to intervene in the markets and the UK defined pension fund sector nearly collapsed as the sharp increase in gilt yields triggered collateral calls for pension funds that had employed derivative-based liability-driven investment strategies (LDI). On 14 October, Truss sacked Kwarteng, while she lasted less than a month after the budget. One UK tabloid newspaper measured her tenure against the shelf life of a lettuce.
Stories for the grandkids
As market events go, the debacle stands alongside such other episodes as the withdrawal of sterling from the European exchange rate mechanism in 1992. It might not have been as bad as the collapse of Northern Rock and other banking institutions in 2007-2008, but it did threaten the future of millions of pensioners’ incomes and the very stability of the UK government’s fiscal position. A year on and 10-year gilt yields are at 4.3% and the fiscal outlook for the UK is not great. The recent Office for Budget Responsibility (OBR) report on Fiscal Risks and Sustainability highlighted some significant structural challenges in the UK’s fiscal outlook such as the future cost of pensions given an ageing society and the promises of the ‘triple lock’; the cost of meeting net zero commitments; and pressure to increase defence spending in response to heightened geopolitical risks. In addition, there is the fiscal cost of increased health-rated inactivity in portions of the population; and the fiscal cost of quantitative easing now short-term interest rates have risen above the yields on the government bonds bought by the Bank of England in recent years.
The conclusion is clear. There needs to be structural reform in fiscal policy to prevent a crisis of sustainability which could mean higher real yields and a weaker currency. If we are in a higher interest rate environment relative to the last decade, then the mere cost of servicing debt is going to be a massive strain on taxpayers. That makes policy decisions even harder. A higher risk premium paid to government bond investors is likely to result.
Achilles heel for bond markets?
More and more commentators are pointing to the vulnerability of bond markets to rising government deficits and debt levels. The recent downgrade of the US by Fitch contributed to the Treasury market sell-off over the summer. Reducing central bank balance sheets at a time of excess borrowing by governments has shifted relative supply and demand dynamics in bond markets, potentially meaning higher real yields and steeper yield curves eventually.
In the UK specifically there is deep public dissatisfaction with the state of public services such as healthcare and education. The number of working days lost to industrial action in large part reflects the demand for more investment (pay) in the public sector, and related industries such as the railways which have strong oversight by the government even though they are operated by private companies. Politicians typically react to this by throwing more money at the problem – a day hardly goes by without a government minister pledging that more is being spent on the National Health Services (NHS) or on schools. This week’s UK labour market data showed public sector wages up 12.2% in the year to July. Rising wages are as much a fiscal problem as an inflation problem for the UK. With little more than a year to go before a likely general election, how the UK meets voter expectations on public services will be the key political point.
Debt sustainability should be part of the debate. On current OBR projects, the longer-term outlook for the UK is for net debt to GDP to rise to over 120% of GDP by mid-century. In the long-term projections, rising health-related spending is the key driver of higher public sector spending and deficits. There are tough political choices to make regarding the provision of health services in the UK. It is an extremely sensitive subject especially against a backdrop of rising waiting lists and long-term inactivity related to, among other things, COVID-19 (which is on the rise again).
But for now, gilts have some attractions
From a tactical point of view, I am quite positive on gilts. Rates are high and even if the Bank of England (BoE) takes the bank rate to 5.5%, it is close to being done. Inflation is coming down and there are signs the housing market is now starting to feel the effects of higher mortgage rates. Gilt prices are low – the City’s personal account trading favourite, the 0.5% 2061 gilt still trades below 30p. The price return to par of gilts in issuance should not be overlooked as a “fairly” risk-free trade. In the wake of the European Central Bank’s 25 basis points (bp) rate hike and the suggestion it has now done enough to bring inflation down, bonds in general should benefit from the peak in official interest rates (despite higher oil prices and some volatility in headline inflation data). There has been a lot of monetary tightening, bond yields are higher than they have been for years and it is likely that both growth and inflation will be lower in 2024. Real returns to bond investors should be healthy over the next year.
Furthermore, in my experience, concerns about debt sustainability tend to be long-term. It is hard to trade bonds on fears of multi-year rising debt-to-GDP ratios. Just look at Japan. The UK, with its own currency, still has monetary flexibility and can choose an inflationary approach to dealing with debt in the extreme. That option is not available to the likes of Italy or Greece or other members of the euro and the European Union’s fiscal arrangements. The UK is not in a great place, but this is not Greece, Portugal, Spain and Italy in 2012!
However, there are longer-term concerns about gilts given the political and fiscal outlook. The pension debacle last year has structurally reduced demand for long-term gilts and inflation-linked bonds. There is going to be more supply. International investors are unlikely to increase allocations to the UK given the policy uncertainty a year away from an election which is likely to see a change in the party in power. And maybe there is more pain in the short term if the BoE feels compelled to do more than the one hike that is currently priced in.
Cheap UK stocks
The ongoing discount of UK-listed equities to the rest of the world may also reflect some of these policy concerns. There are good UK-based companies and the continued flow of venture capital and private equity money to the small and mid-sized sector reflects this. But my impression is that global equity investors don’t particularly like the UK. The decision by Arm Holdings to list in the US does little to improve the optics. UK equities are cheap, they pay decent dividends in the large cap area, and there are real areas of strength in technology and healthcare but it’s much more a bottom-up than a top-down story.
AI to the rescue?
Can AI play a part in the fiscal challenge? The only way to square the circle of meeting expectations of quality of public services without raising taxes to onerous levels is to improve growth (therefore tax revenue) and make the public sector more efficient. There can’t be many more institutions with more data than government. AI could be used to reduce bureaucracy in government institutions, optimise procurement within the NHS, deliver a higher standard of education and provide a higher minimum level of teaching for disadvantaged students. Surely large language models and machine learning can help simplify the complexity of budgets to reduce waste and improve delivery?
This is very hopeful
Government finances are generally in the mess they are in precisely because governments are not very good at planning and coordination across policy areas and so many fiscal decisions are driven by, as our American cousins would say, pork barrel politics. Controls on AI because of its potential impact on jobs or because of security concerns are more likely than fully embracing the potential of technology to improve the living standards of those more reliant on public services. We await the politicians with vision.
Increased demands on public sector budgets coming from the pandemic and the energy shock have been seen across developed markets. Growth is now slowing which will put additional pressure on budgets, especially if unemployment rises. In the US, fiscal impulses, even if coming indirectly from the subsidies offered under various Biden Administration policies, are a key reason why growth has held up. Fiscal dominance, however, might mean higher interest rates for longer, or increased pressure on central banks to accommodate fiscal spending. We might not have seen the last of central bank buying of government bonds.
Cheap borrowing no longer
None of this means being bearish on bonds today. It does mean, however, that over the medium term we can’t rule out bond yields being another 100bp-200bp higher than where they got to in 2023. At the same time, unless inflation falls and stays very low again, the days of the UK government being able to borrow for 30 years at less than 1.0% are likely to remain firmly in the past.
(Performance data/data sources: Refinitiv Datastream, Bloomberg). Past performance should not be seen as a guide to future returns.