Back
I am back from a break hiking in Ireland (my tip: bring your waterproofs). The first thing that struck me on returning is that – and this is not always the case – I think equity and bond markets broadly agree on the economic outlook. Equity markets are continuing their recovery from April lows and volatility remains low. Rising prices and low volatility tell me that equity investors appear confident that 2026 will be a decent year for earnings and economic growth. And I think bond markets broadly agree. The US bond market has (more or less) two cuts priced in for year end. Meanwhile the UK has 1.5 priced in for the next year pointing to a terminal UK base rate of around 3.5%. These rate cuts are small and have already been well flagged. Central bankers do not yet seem to be too worried that economic growth is about to fall.
That is, of course, a relatively optimistic outlook. But one less positive implication is that if you are waiting for interest rates to fall I am not sure relief is on its way. This applies to mortgage borrowers, property markets and leveraged private equity owned businesses (of which there are plenty these days). And, unfortunately, it also applies to our own government. Labour was under pressure again this week after a reshuffle of its economic team. One risk to the outlook is that the UK gets stuck in some sort of doom loop where higher borrowing costs push up deficits, and higher deficits mean higher borrowing costs. Greece and Italy ran into this issue in 2011 requiring wholesale bailouts and debt restructuring for Greece. We are not anywhere close to bringing in the IMF yet (phew). But I would say the problems in the UK feel the most acute because growth here has been relatively low over the last few years and we now have the highest borrowing costs in the G7:
Even with this structural backdrop, there are a few reasons for relative optimism. First, the UK (unlike Italy and Greece) prints its own currency and so has more control over bond repayments. Second (and linked to this), the Bank of England is still selling around £100bn of gilts back to the market under its QT program. This is clearly a policy choice and is adding to the rising yields you see in the chart above. But this could easily be reversed and, if necessary, the selling could turn into buying if the market started running into real problems. And finally, it is worth remembering that a large part of these moves are global in nature. Much has been made of the fact that the UK 30 year yield recently reached 5.7%. But long bonds everywhere are under pressure:
One large natural buyer for long bonds are defined benefit pension schemes. The problem is these are in structural decline and, to add to this, as yields rise their liabilities shorten so they end up having less demand for long bonds. Yields will keep drifting higher as the market find new buyers to replace them. And on that subject, I am 55. A total return of 5.7% p.a. is not that bad! And the 2061 bond offers an after tax yield of 4.5% for a 40% tax payer. This is not investment advice, but if you are brave enough to do this I’d also advise you to unplug the Bloomberg terminal you use for pricing.
That said, dislocations in government bond markets still remain a real risk for us. The other risk we see is that the rosy market outlook for the economy that I mentioned above proves to be too optimistic. Here I think higher bond yields actually offer some sort of comfort. I mentioned above that the terminal rate for UK base rate is priced at around 3.5% today. But I think base rates could easily be back at 1% or lower if a nasty recession did turn up. And I would expect longer term yields to fall in tandem if this happened. Even with the latest political and market gyrations in the UK this week, government bonds still look to be the right hedge for equity investors for me today.
Chris Brown, CIO
cbrown@ipscap.com
The value of investments may fall as well as rise and you may not get back all capital invested. Past Performance is not a guide to future performance and should not be relied upon. Nothing in this market commentary should be read as or constitutes investment advice.
