Relative stability to close out the year

Relative stability to close out the year

Taking five charts of key indicators, Robert Plant, Portfolio Manager, Multi-Asset Solutions, analyses how they inform us about the future path of interest rates and the likely length and severity of impending recession.

After a tumultuous few months for UK politics, that led to the resignation of Prime Minister Liz Truss, there are signs that markets have stabilised. The prospect of significant government borrowing to fund the largest (unfunded) programme of tax cuts in decades created significant volatility, as well as serious concerns around the sustainability of government borrowing going forward. Yields rose sharply and UK credit default swap rates (a measure that reflects the credit risk of the UK government) spiked higher – a sign that markets were unwilling to absorb a large increase in gilt supply on the prevailing terms.

However, as shown below, a budget u-turn appears to have had the desired effect with UK credit default swap rates, and by implication markets’ perceived risk of a sovereign default, returning to levels in line with peers.
Credit Default Swap Rates
Credit default swap rates

Source: Bloomberg and Columbia Threadneedle as at 29 Nov 2022.

Peak UK base rate revised lower

The terminal rate (the level at which a central bank stops raising interest rates) in the UK was expected to rise beyond that of the US, peaking at 6.5%. Since the u-turn, however, expectations have been revised to 4.6% (below the expected terminal rate for the US).

Fiscal tightening and recession in 2023 should supress demand-pull inflationary pressures sufficiently to allow the Bank of England to end its hiking cycle sooner than previously expected.

Terminal Interest Rates
Terminal interest rates

Source: Bloomberg, as at 29 Nov 2022

Even with the reversal, however, political pressure to provide additional support for households hit by the cost-of-living crisis remains. Inflation has been the dominant theme this year, with signifciantly higher gas prices and strong wage growth driving the cost of living to multi-decade highs.

There are few developed countries which have felt this as acutely as the UK, with consumer prices rising 11.1% year-on-year in October. Unlike the US, inflation in Europe and the UK has been driven primarily by higher gas and food prices – a direct consequence of the war in Ukraine and the continent’s dependence on Russian gas.

UK alone with GDP still below pre-Covid levels

UK growth has been weak, beset by headwinds from fiscal and monetary policy. It is the only G7 country to have not seen GDP recover fully to its pre-Covid level.
% change in Real GDP from Q4 2019 level
percentage change in real gdp from q4 2019 level

Source: Bloomberg and Columbia Threadneedle, as at 29 Nov 2022.

The Bank of England has moved swiftly this year to combat the inflation threat, raising interest rates at the fastest rate on record despite the high likelihood of a recession in 2023. After a prolonged period of low inflation and interest rates, the era of ‘cheap money’ appears to be over, and this will, and already is beginning to, have a profound effect on the cost of servicing mortgages.

Housing market’s processing of policy events continues

Historically, house prices and mortgage rates have shown a strong inverse relationship, where higher mortgage maintenance costs typically curtail the demand for new homes through pressuring disposable incomes. The implied large correction in house prices shown in the chart below will, however, be contained by the scarcity of housing supply. House price data has a lag and we are only just beginning to see the effects of higher rates starting to feed through.
Mortgage rates

Source: Macrobond and Columbia Threadneedle, as at 29 Nov 2022.

Nationwide’s measure of house prices fell by 0.9% month-on-month in October – the first fall for 15 months and the sharpest decline since the early months of Covid. The RICS Residential Market Survey showed that the net balance of surveyors reporting that house prices have risen over the last three months saw its largest monthly fall from +31 to -2 in October.

While bond yields have fallen from the September highs, mortgage rates haven’t fallen as much with banks increasing spreads, due to the elevated risk of lending. The fall in mortgage rates should gather pace over the coming months as markets’ expectations for the UK base rate continue to moderate.

RICS price balance (% surveyors reporting increases vs. decreases)
RICS price balance

Source: Bloomberg, as at 29 Nov 2022.

The backdrop for risk-assets will continue to be challenging

Looking forward, the path of future interest rate hikes and the length and severity of recession, will be extremely consequential for UK markets. Policymakers will want to be certain that inflationary pressures have indeed rescinded before easing policy and, therefore, we expect the backdrop for risk-assets will continue to be challenging. The UK faces particular problems with a wide current account deficit, high sensitivity to interest rates and the prospect of fiscal austerity. We expect a protracted if mild recession in the UK.

Robert Plant
Director, Portfolio Manager, Multi Asset Solutions
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