UK government bonds caught in £-Sterling's downdraft?

21 October 2016

Over the course of the last months I had repeatedly warned on these pages that UK government bonds (gilts) had run out of further upside return potential. This is because the fall in yields - which had fuelled their stellar rise in value - necessarily had to come to an end as they fell ever closer to 0%. Some may therefore have interpreted the distinct decline in bond values and rise in yields over the past week as the long awaited reversal of the previous trend. The short term chart at the top (1 Sep - 20 Oct) shows this fall in UK gilts values, represented by the FTSE Gilts All Stocks total return index.

What the chart also indicates is how, as of late, this bond sell-off appears to have been quite closely following the fall in the external value of £-Sterling which we wrote about at length over the past weeks. Does this mean international investors are turning their back on the UK gilts market, or worse on UK assets as a whole? This could spell trouble for the financing by foreign investors of the UK's current account deficit which in the past has led to a steep rate rise to prevent a collapse of the currency.

No, not quite and anybody who seriously suggests that this is in train would be purely speculating or scare mongering. What we are seeing though is a return of inflation expectations, triggered by the price increase of imported goods because of the currency falls. Their absence had deeply worried economists, central bankers and the investment community, because deflationary conditions discourage economic activity. Therefore, and as long as UK economic activity remains in at least a mild uptrend, a temporary uptick in the rate of inflation can actually turn into somewhat of an economic stimulus, as the nominal growth that comes with it can create a rising tide that lifts all boats.

It would seem markets saw it similar and so both the fall in £-Sterling, as well as gilts stopped over the course of the week and even reversed towards the end of the week. There were some suggestions that this had more to do with UK politics, based on more conciliatory vibes out of No 10 which suggested that perhaps the hard Brexit route of the previous week might not be so hard after all. This even resulted in the amusing question from amongst our investment team whether the £-Sterling exchange rate had now officially assumed the role of the political opposition in the UK.

Indeed, politics had much to do with the recent currency and then bond yield moves, given it was Theresa May's party conference speech that triggered it. Her seemingly hard Brexit stance raised the political risk for the longer term UK outlook. On the other hand, and for the shorter term, her commitment to better the lives of the working class through redistributive policies could result in a boost of consumer demand which would constitute a very welcome '˜shot in the arm' for the UK economy.

As you can probably tell, it never gets boring for us at the moment, but even we have been surprised that May single handedly and quite immediately fulfilled on her promise to deliver better yields for savers - genius! Alas, probably not quite what she had in mind when she fired her threatening salvo against the UK's central bank and its economy saving, but unpopular amongst savers policy, of ultra-low rates.

We commented before that we have entered a period during which politics may have a bigger impact on short term market direction than the actual economic trend and we had plenty of evidence for this recently. In the world beyond the UK and the '˜softening of a hard Brexit' perception, political risk factors appeared to be on the decline too, as maverick US presidential candidate Donald Trump's temper made him lose more ground. In the Middle East ISIS was on the retreat from their '˜capital' Mosul in Iraq.

But before becoming too optimistic, we are observing with increasing concern the Russian navy re-enforcement of their Syrian presence which could lead to a very unwelcome tension increase between the US and Russia, as Putin may underestimate Obama's commitment to the Syrian people in the last months of his presidency. Politicians ill-advised pressure on central banks to rapidly raise rates is a further worry point, in light of January's stock market turmoil after the just 0.25% US rate rise.

On the side of the real economy, we are pleased to see the majority of companies' Q3 earnings reports come in above expectations which bodes well for a return to a positive earnings trend which would help to underpin the recent stock market rally with hard fundamentals.

Central bank policy uncertainty was also on the decline over the week, with a 2nd US rate rise in December looking increasingly certain, while on the other side of the Atlantic a continuation of the Eurozone's QE program beyond March 2016 appears more certain. This at least is my interpretation of ECB's Mario Draghi's comments that he and his colleagues had not even discussed a tapering down of the QE program yet.

Further support for the technicalities of the ECB's QE program came paradoxically from the UK, when the UK gilt sell'‘off also lifted yields of many Eurozone government bonds as a result of the international connectedness of capital markets. This has moved more than half a trillion €-EUR worth of Eurozone government bonds back to yield levels where they are eligible for QE purchases. This should quell concerns that the ECB's QE program is running out of capacity for a good while.

In summary, a fairly even balance of good but also potentially concerning news flow, which tells me that our neutral positioning of the Tatton portfolios continues to be appropriate. Our portfolio changes of the past week have in so far been more about refining our fund selection in various asset classes and regions, as well as taking some profits in UK funds and reinvesting the proceeds in some higher return prospect areas across Asia.