UK investors breathed a sigh of relief last week as the UK Core CPI inflation number came in lower than expected. Whilst a slight reduction in the rate of price increases was expected by many, the reported number of 6.90% was lower than the predicted 7.10%. The “headline” CPI number came in at 7.90% versus an expected 8.10%.
This welcome slowing of inflation had an immediate and notable impact on UK assets, with Government Bond yields falling (meaning an increase in capital value), Sterling weakening and UK equities rising. Here we show the yield on the UK 10-year Gilt over the past year:
Data from Factset
Whilst the move may not look like much on the chart, compared to the extreme volatility in bond markets over the past 18 months or so, the sensitivity to expected changes in interest rates (known as duration) meant that gains from some bond funds have been significant in a short space of time.
My colleagues and I have been highlighting the attractiveness of bonds for a little while now as the income yields on offer are the most attractive they have been since about 2008. However, we should warn readers that, despite our cautiously optimistic outlook on bonds, it might not all be plain sailing from here.
Victory in the war on inflation?
Undoubtedly, the positive surprise in the inflation data gives some hope that inflation might finally be rolling over here in the UK. As we have discussed before, the UK is somewhat of an outlier in the developed economies, particularly versus the US, where disinflation (i.e. prices are still rising but at a slower rate) has taken hold.
A fall in the rate of inflation was widely expected as the very high energy prices from last year begin to work themselves out of the numbers. Inflation is calculated as a rolling number, therefore, because Oil and Gas prices began to fall in the summer of 2022, and have stayed lower since, the “base effect” means that inflation will start to fall, purely as a function of the maths.
But this doesn’t mean we are out of the woods quite yet. Despite positive news on inflation, labour markets remain very tight, by historical standards, with few unemployed people and not many job openings. Central banks worry that the dynamic emboldens workers in their salary negotiations and that wages will continue to rise quickly. In the worst case, this could lead to the dreaded “wage price spiral” where higher wages mean greater affordability, thus driving up prices further. Workers then negotiate higher wages to keep up with rising prices, which drives them up further, and so on.
In our recent video update, we discussed that interest rate adjustments are a blunt tool in managing inflation in an economy. Changing the course of an economy can be likened to changing the course of a supertanker. It takes time. Therefore, the US Federal Reserve, the European Central Bank and the Bank of England are all expected to continue raising rates for the time being. Perhaps only once or twice more in the US but the jury is still out for the UK. Some forecasters expect rates to rise to 5.75%, some expect them to go above 6.00%.
All of this means that whilst we are cautiously positive on the medium-term outlook for bonds, there might be some more difficult times over the shorter term.
What does this mean for mortgages?
After the inflation number was released, markets repriced their expectation for interest rates rises downwards, hence the fall in bond yields. There are early signs lenders might reduce the rates on new mortgage loans, which will be welcome news to those whose fixed term deals are coming to an end.
But the pain for UK households having to find new mortgage deals this year, and probably next, will still be severe. With mortgage interest rates set to more than double, and almost triple in some cases, we continue to believe that the greater repayment burden combined with a widely predicted fall in house prices, could have a very negative impact on people’s propensity to spend and, therefore, the economy as a whole.
According to data from the ONS, which is to the end of May 2023, house prices are still rising but at a much slower rate than for the past 2 years. The following chart clearly shows that the rate of growth has slowed very sharply and does not have far to go until growth is negative, i.e. prices are falling:
How far house prices might fall is anyone’s guess. Some are predicting a fall of 10% to 15%. Certainly, if this were to transpire, it would have a profound impact on people’s sense of wealth.
Light at the end of the tunnel?
Whilst this all sounds a bit doom and gloom, there is light at the end of the tunnel for investors. As I’ve already mentioned, we’re more upbeat about the outlook for bonds than we have been for many years. That being said, both equity and bond markets might remain volatile until we see a definitive end to Central Banks’ hiking cycles, but the consensus is that we are not far from the end, particularly in the US.
Returns so far this year have been stronger than one might have expected given the rather gloomy economic outlook. Investors who lost their nerve in 2022 and moved to cash might be regretting that decision now given that medium risk multi asset portfolios have returned somewhere in the region of 4% to 5% in the past 6 months.
For those considering moving to cash now, yes, savings rates on cash look very attractive at the moment. However, an interest rate of 6.00% on a 1 year fixed rate bond still generates a loss in real terms, i.e. when adjusted for the rate of inflation of 6.90%. A wealth of empirical evidence shows that the only way to beat inflation over the long term is to stay invested and ride out short-term difficult periods.
Until next time, stay well.