Bedrock’s Newsletter for Friday 30th September, 2022

Friday 30th September, 2022

It has been another tumultuous fortnight for markets, with downward moves showing red across the screens. The themes driving investor angst remain much the same as discussed in many of our recent newsletters: rising interest rates, stubborn inflation, recessionary clouds gathering, energy market dislocations, and spiking geopolitical risk. New developments across many of these in the last two weeks have added to the downbeat sentiment. A (seemingly shambolic and desperate) mobilisation in Russia, the illegal annexation of large chunks of Ukrainian territory, renewed nuclear threats, and sabotage of submarine gas pipes in the Baltic have kept the geopolitical stakes high and sent a further spasm through European gas markets. German inflation has hit double digits for the first time in 70 years (+10.9% CPI). Key leading indicators of global economic activity, from German business sentiment surveys to Korean industrial output measures have added to evidence that the world stands on the cusp of recession. Meanwhile, the central bank hiking cycle continues apace: over 500 bps have been added to policy rates around the world since we last wrote, including the Fed’s third consecutive 75bp increment. The response from markets has been violent. Sovereign bonds sold off; US 10Y yields briefly gained a 4 handle this week (before easing back to 3.74% today) while European yields also marched up (as did peripheral versus German spreads). The S&P 500 this week retested its June low and was currently hovering above it as we went to press. Other gauges have joined the rout, with the NASDAQ, Nikkei, and STOXX Europe 600 all down sharply this week (-3.0%, -2.7%, and -4.2%, respectively, at Thursday’s bell). This year’s continued tandem slump of both stocks and bonds has erased over $18tn of combined value from US equity and fixed income markets – twice the value destruction of the global financial crisis.

UK assets led some of the most dramatic moves after the new government’s ‘mini-Budget’ spooked markets last Friday. The substance, the context and the messaging around the budget all primed markets to respond adversely. Confidence in the UK economy had already been dwindling: dragged down by Brexit, dismal productivity growth, and a decade of austerity, it is the only G7 economy still to recover to its pre-pandemic size. During this summer’s long leadership campaign, now Prime Minister (PM) Liz Truss batted away scrutiny of her radical, unorthodox fiscal plans – and once in office, her inexperienced team sacked the most senior, crisis-tempered official at the Treasury, and dodged assessment of its fiscal plans by the Office for Budget Responsibility by refusing to designate the budget as a ‘Budget’ (employing the euphemistic ‘Fiscal Event’ instead). These were not encouraging signs for investors. Then, even as inflation raged, the budget delivered the largest – inflationary – tax cuts in 50 years. These were unfunded – to be covered by vast new borrowing, just as the cost of borrowing is shooting up and the Bank of England (‘BoE’) preparing to sell gilts into the market to shrink the money supply (Quantitative Tightening, QT) to tackle inflation. While the excuse for the cuts was to promote growth, they were wildly unequal (two-thirds of the gains from the income tax cuts will go to just 50,000 individuals, the highest earners with incomes over £500,000, representing just 0.1% of the population), even though tax cuts to high earners have long since been shown to have no positive effect on growth (largely due to their low marginal propensity to consume). The market’s assessment was swift. Yields rocketed: 5y gilt yields climbed +51bps on Friday last week (the highest daily rise since 1985) in selling that continued well into this week. Unusually, this was coupled with a brutal sterling sell-off (ordinarily, rising rates can be expected to lure investors, driving up demand for the currency). At its lowest, the pound collapsed to 1.03 to the dollar – thereby smashing its previous record low of 1.05 in 1985 – having stood at 1.12 before the Budget. While the exchange rate calmed, the bond market rout raged on into this week, prompting both US Fed officials and the International Monetary Fund to voice alarm at the threat to global market stability. The Budget had set up a direct clash of contradictory fiscal and monetary policy (likened by many to driving with both accelerator and brake to the floor), putting pressure on the government or BoE to step back. In the end, a collapse of liquidity imperilling the UK pension fund sector and its counterparts forced the BoE to step in with renewed (and, it insists, temporary) Quantitative Easing to avert a systemic financial crisis. This arrested the sell-off – but the net effect is dramatically higher yields and more expensive credit for government and private borrowers alike.       

The impact on UK politics is only just beginning to play out – though it is happening quickly. Truss has performed only marginally better than the misspoken metaphor of her promise on election to ‘hit the ground on day one [sic]’. Scarcely three weeks of her premiership had elapsed – and politics were frozen for 10 days of that in the mourning period for the late sovereign – before her government had its back to the ropes after the spectacular budgetary misstep. The government’s standing with voters has fallen swiftly this week: latest polls put the Conservatives a whopping 33 points behind Labour, well into wipe-out territory if recreated at a general election (the next is due by January 2025). Though whispers soon emerged from Westminster that Tory MPs had begun submitting letters of no confidence in Truss’ leadership (only a minority of whom supported her in the first place), we struggle to believe the speculation that Truss will be gone by Christmas. Perhaps she will shepherd her Chancellor of the Exchequer to fall on his sword? Either way, the UK’s chronic political instability and poor economic prospects continue to act as a massive drag on business investment. And even if the market situation has now largely stabilised, the damage done via sharp yield rises means many UK homeowners – a large chunk of the Conservatives’ core electorate – will in the coming months confront dramatic increases in their mortgage payments, some of which may prove unpayable (most UK mortgages fix rates for 2 or 5 years). Voter anger is likely to grow and with it pressure on the PM.

While the sharp moves in sterling were this week largely driven by the domestic developments, in forex markets there are always two sides to every coin: one person’s weak pound is another’s strong dollar. Though the pound fell against all comers (even Bitcoin!), it was far from alone in coming off worst against the US currency. All G10 currencies are down substantially against the dollar YTD, ranging from a -7% fall in the Swiss franc to stinging drops of -21% and -25% for sterling and the yen, respectively (the euro is down over -15% YTD). Beyond the G10, currencies from the Korean won (-21%) to the South African rand (-12%) are down to decade lows. While it has pared some of its gains in the latest trading, the DXY (an index that tracks the strength of the dollar against a basket of other currencies) is up +16% this year, well above the spike of the 2020 covid shock and at levels not seen since the early 2000s. The dollar’s haven status and rapidly rising US rates are the twin magnets pulling investors toward the greenback. But many countries are now living out Nixon Shock-era Treasury Secretary Connally’s dictum that ‘the dollar is our currency but it’s your problem’. Broadly, given its central role in global trade (it is involved in around 40% of global transactions, according to the IMF), a strong dollar means higher prices for importing countries, further entrenching inflation. For countries with heavy USD-denominated debts – many emerging markets (EM) – it means sharp rises in the cost of interest payments. Many past EM crises have been linked to a strong dollar and rising US rates, and now default risk is climbing in countries including Argentina, Kenya and Egypt. Finally, for investors it means that exposures that look flattering in local-currency terms look far uglier denominated in USD. For example, Japan’s Nikkei 225 index has this year held up reasonably well, down -8.2% YTD in yen terms (compared to the S&P’s -23.6%). But translated into dollars this becomes a far less friendly fall of -23.6%.

Some central banks have started to push back. Last week the Bank of Japan intervened directly in forex markets for the first time since 1998 (and the Asian Financial Crisis) when the yen fell to a 24-year low against the dollar of ¥145.9; the Bank’s purchase of ¥2.8tn ($19.7bn) reeled it back to ¥140.3. Meanwhile, the sinking of the (closely managed) Chinese yuan to 7.25 to the dollar, its weakest since 2008, moved the People’s Bank of China (PBoC) to act – though less directly than their counterparts across the Sea of Japan. The PBoC raised the cost of shorting the renminbi via raised reserve requirements and warned market makers not to facilitate ‘excessive’ wagers against the currency. The Bank of Korea has also intervened directly in forex markets and rumours are growing of a potential emergency won-dollar swap deal with the US.

What is the path forward for the dollar? Although it has stepped back from its highs in the most recent sessions, it remains historically mighty, adding strains to the global macroeconomic picture, and we see no immediate prospect of substantial softening. As ever, much will depend on rate differentials, rendered more complex by a rapid worldwide hiking cycle. Signs of real weakening in the US economy, with attendant expectations of looser monetary policy, would be the likely trigger for a meaningful decline – but the latest data suggest this is some way off. In the meantime, the forex and rates picture remains differentiated, with some currencies (such as the Mexican peso and the Brazilian real) holding out much better against the dollar and gaining versus other peers. This is a highly challenging environment in which to invest, and we can only champion strong diversification across portfolios, including a meaningful allocation to uncorrelated alternative strategies given how little diversification bonds and equities are currently offering with respect to each other. In particular, we think that this is a great environment for discretionary macro managers to shine in.


 

______________________________________