26th May 2023
In a week that saw Boris Johnson under another investigation related to breaking Covid rules, rows over immigration and inflation numbers disappointing to the upside, it felt like going back in time. While in the US, Democrats and Republicans are still talking about the debt ceiling.
The UK has an inflation problem, and the latest figures demonstrate the challenges facing policymakers. On the bright side, headline inflation fell back to single figures, but prices are still rising quickly. Consumer Price Inflation (CPI) eased to 8.7% year-on-year in April from 10.1% in March, driven by a large fall in energy prices (specifically the large rise in energy bills in April 2022 dropped out of the series). The price of natural gas (which is the key determinant of UK electricity prices) has fallen sharply and this will ease inflationary pressures as it feeds through to domestic energy prices. However, food prices are still rising strongly but again there is hope that they will fall. Perhaps the most challenging aspect of the numbers was that core inflation (which strips out the most volatile items like food and energy) rose to a 30-year-high at 6.8% year-on-year, driven by inflation in the Services sector. This inflation is likely to prove stickier and harder to wash out of the system unless the economy falls into recession. On that front, UK economic data has been more robust than expected over recent months and this week the IMF upgraded their economic growth estimate for the UK to 0.4% in 2023, but the economy is still fragile.
Headline UK inflation fell in April, but underlying price pressures climbed higher
Inflation rates - Year on Year % (YoY)
Source: Bloomberg, UK Office for National Statistics
This presents a dilemma for the Bank of England. Whereas in the US where markets are forecasting a pivot from the Fed (albeit this optimism is fading), investors are expecting further interest rate rises in the UK. Following the inflation data, an interest rate rise next month is seen as a certainty and current expectations are for a further three rate rises by the end of the year, which would take UK interest rates up to 5.5%.
Expectations for UK interest rates have jumped sharply following inflation data
Implied UK interest rate (%) after the Bank of England meetings in June and December 2023
This will create further challenges for the UK economy. Monetary policy operates with a lag and the impact of changing interest rates may only be felt 12 to 24 months after (the precise lag is far from clear but consider this a best estimate). One major reason for this is that for many people or companies with fixed rate debt, until you need to refinance debt you do not feel the impact of the change. As we flagged last week, “around 1.3 million households are expected to reach the end of their fixed-rate term between 2023 Q2 and the end of 2023. For the average mortgagor within that group, monthly interest payments will increase by around £200 a month if their mortgage rate rises by 3% points – the increase implied by quoted mortgage rates.” And with a further move up in interest rates that increase could be even higher.
From an investor’s perspective, this can create opportunities. Yields available in fixed income have increased dramatically over the last 12 months to attractive levels. Yields are highest at shorter maturities (a so-called “inverted yield curve”) and may provide the opportunity to lock in an attractive return, while longer bonds are most likely to provide protection if the economy does fall into recession. Whereas in 2022, bonds fell concurrently with equities on an inflation / interest rate shock and so failed to diversify portfolios, higher starting yields should provide a buffer and we would expect bonds to act as a diversifier in a recession.
Keep on talking
In the US, discussions over the debt ceiling are ongoing. It is a quirk of the US that there is a statutory debt limit imposed on the US Treasury and Congress needs to approve any increases. When Congress is divided (like now, Democrats control the Senate and Presidency, Republicans control the House of Representatives) there can be a stand-off and talks often go to the wire before both sides agree on a deal to keep the government functioning. However, occasionally agreement is not forthcoming, and we have seen the government shutdown in the past.
The looming deadline is 1 June when the US could run out of cash to pay all of its financial obligations. Talks between President Biden and Republican House speaker Kevin McCarthy are ongoing, and they are believed to have moved closer to a two-year deal to limit government spending and so avert a potential US debt default. While our expectation is that agreement will be reached, this could be a source of market volatility over the coming week.
Gareth Thomas Head of Investment Management
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