Is a soft landing possible for the UK economy?
The UK economy is likely to be hit particularly hard by the current global inflation shock and is slowing sharply with a risk of recession in the second half of 2022, albeit Bruna forecasted growth to be flat over this period. Her forecast of a 2.7% fall in real disposable income would be the highest since records began, exceeding that of the 1970s oil crisis. This is compounded for the UK economy by its heavy reliance on the consumer. That means offsetting gains from a recovery in manufacturing post-lockdown, will have a much smaller positive impact than for other European countries facing a similar cost-of-living crisis.
Business investment has been muted and has even fallen so far this year, despite there being meaningful tax benefits arising from such activity. Although investment activity is expected to pick up in the second half, supply chain disruption and weaking demand will likely cap spending. UK exports have also failed to rebound to pre-pandemic levels and with Brexit acting as a continued headwind such exports are not expected to pick up meaningfully from here.
On a more positive note, the labour market in the UK remains extremely strong with vacancies exceeding unemployed workers. Whilst the data is very strong, the high level of turnover potentially overstates the situation, and the participation rate is currently lower than pre-pandemic. This tight labour market is likely to support services inflation, but the key driver of high inflation is externally imported core inflation, energy being the most obvious component.
This creates a challenge for the Bank of England who have a slowing economy but high externally driven inflation and a population that can respond to this via a tight labour market. Despite this near-term inflationary pressure, the Bank is distinctly dovish over the medium term. Therefore, two more rate hikes are forecast for this year followed by a pause into the middle of next year. Greater than expected fiscal support could force further hikes, given the tightness in the labour market, but it should be noted that further monetary tightening will arise when the Bank starts selling its stock of gilts back to the market, forecast to be done at a rate of £10bn per quarter, starting midway through the second half of the year.
In summary, although economic growth is slowing and further headwinds exist, the deployment of lockdown savings by the UK consumer, a strong labour market and additional fiscal support from the Government should support the possibility of a soft landing. However, the outlook is finely balanced as inflation pressures persist and there remains uncertainty around the level and nature of fiscal support the Government will announce over the coming months.
What is the outlook for corporate bonds?
We focus on three core factors when assessing corporate bond markets; fundamentals, valuations and technical.
Starting with fundamentals, companies are reporting good results, with leverage levels decreasing and interest coverage high, leading to credit upgrades. While the global default rate is set to rise as the economy weakens, it is projected to remain below average, unless there is a significant further deterioration in the global economy.
Valuations have already moved to reflect the more challenging and uncertain macro-economic environment. Global credit spreads have risen sharply from last year’s lows and are close to the long-term average, or just above the average for sterling corporate bonds. It is worth noting that credit spreads have only temporarily traded wider than that longer-term average over the past decade, so relative to more recent history they are now at attractive levels. That suggests that valuations are supportive, a meaningful shift from the somewhat stretched valuations of last year.
Technical factors appear mixed, despite the big negative impact from central banks reversing their quantitative easing plans and announcing measures to actively sell the stock of bonds that they have accumulated. That takes away a huge source of buying support that had helped push bond yields to record lows and squeeze credit spreads. However, most of these changes have already been announced and are already impacting markets. We would focus on the offsetting positive factors, with a reduction in supply of new bonds. This is not just temporary disruption resulting from the Russia/Ukraine war as after several years of record issuance, the rise of bond yields means that refinancing is no longer compelling. Companies have also improved their balance sheets and raised cash over this period. With the slackening of economic growth likely to put some planned capital expenditure plans on hold, the new demand for new finance is reduced. That suggests the overall technical outlook is neutral, rather than negative.
With strong company creditworthiness, low issuance, and valuations at fair levels, corporate bonds are clearly attractive. However, looking at the wider investment market, we can see that this is a more challenging environment with an uncertain macro-economic outlook. If we look at how credit performs during the economic cycle then the current environment, with GDP growth above average but declining, is still associated with positive returns, but we need to manage the downside of recession risks. If that recession risk can be circumvented, the recovery phase is very positive for credit returns.
Credit valuations reflect the more challenging environment. However, we need to focus on stock selection as individual credit risk rises in a downturn. This means we prefer rising stars, high conviction issuers, and defensive sectors. Financials tend to weather the storm better, so we are overweight compared to industrials. We see banks as being much better positioned now than at this stage in previous cycles. We also see ESG as a key component of downside risk management. In this environment, there are attractions to lower-duration credit as it is less vulnerable to policy mistakes and recession fears. However, for those schemes in a stronger funding position, there are now opportunities to de-risk with yields at much more attractive levels than last year and the longer-dated sterling credit market is well populated with creditworthy utilities and housing associations with inflation -linked revenues.
The LDI Investment Solutions Q2 webinar was hosted by Richard Ferris, Director and Client Portfolio Manager for LDI, with presentations from Bruna Skarica, UK Economist at Morgan Stanley, and Rebecca Seabrook, Corporate Bond Portfolio Manager.
