The UK market has been coping with the highest levels of volatility since the global financial crisis, and investors are increasingly wondering whether valuations are now low enough that they might have reached the bottom.
Political risk seems to have increased after the uncertainties generated during the Conservative party leadership campaign and following the disastrous market reception to Kwasi Kwarteng’s mini-Budget.
This has hampered a number of areas but perhaps most notably it has caused the value of the pound to plummet.
Investors will no doubt be keen to know how these shifts will impact their UK bonds and stocks, as well as wondering how much of this disruption is already reflected in valuations and if there is likely to be further pain to come, or whether we are at the start of an upswing.
Simon Murphy, manager of the VT Tyndall Real Income fund, said he would “keep an open mind rather than join the chorus of ‘experts’ certain of imminent failure”.
“It is still early days for the newly appointed Truss government and clearly, given the extreme movements in sterling and gilts recently, there are ‘teething’ problems to say the least in convincing markets and the wider population that a new economic approach focused on tax cutting and regulatory reform are the right way forward,” he said.
But he considered this “initial scepticism” a normal reaction to someone trying to break the prevailing orthodoxy and said that it will take a while before we can usefully evaluate the success or otherwise of the new measures.
Encouraged by a higher sterling against the dollar and the euro than at the time of the chancellor’s Budget announcement – at least at the time of writing – Murphy felt loosely optimistic.
“We already observe an enormous degree of negativity towards the prospects for the UK and that, in our opinion, is creating outstanding investment opportunities in a variety of UK equities for the medium term.”
Invesco global market strategist Kristina Hooper, said one thing investors should pay attention to is the earnings of companies, particularly as we head into the fourth quarter.
“I don’t expect earnings season to be pretty — but the question is how much is already priced into stocks,” she said.
“I’m still prepared for earnings to modestly disappoint relative to current expectations, although that largely appears to have been priced into stocks. I’m more concerned about forward guidance and how the fourth quarter evolves. In other words, earnings reports will join central bank meetings and speeches as the equivalent of ‘must see TV’ as we assess the damage that high inflation and rising rates have wrought, and hear about expectations for the fourth quarter.”
Turning to bonds, Sergio Bertoncini, senior fixed income research strategist at the Amundi Institute, is convinced, despite some positive signals, that “risks remain tilted to the downside” as he has a different picture for sterling to the one painted above.
“Despite dramatic gilt repricing, with the two-year gilts moving from 3.45% on 22 September to nearly 4.40% on 26 September, and similar violent reactions in the currency, we believe investors should avoid trying to catch a falling knife and resist the temptation to jump into the pound,” he said.
“The UK is the only developed market country where policy rates are expected to run above 6% on a 12-month horizon and less aggressive signalling from the Bank of England will accelerate the move below parity. Despite strong movements, we still don’t see the light at the end of the tunnel.”
Pieter Fourie, lead fund manager of the Sanlam Global High Quality Equities fund, framed this as a wider, global bond crisis, but conceded that the UK would be more adversely affected than other countries.
“It is fair to say that the notion that developed market bonds are safe investments has been shattered this year,” he said.
While world bond markets are highly leveraged due to liquidity risk, foreign exchange risk, central bank policy risks and credit risk, inflation, which Fourie called the biggest risk of all, “was never properly priced into the UK gilt market, in particular a year ago”.
Economics 101 states that bonds should have nominal yields above the rate of inflation, yet this has not happened in the UK gilt market for at least the past decade, giving UK investors “a false sense of security”.
“The setback in the bond market in 2022 may well continue as long as Powell accelerates his anti-inflation pivot and reduces the Fed’s balance sheet by $2.5trn in the next two years.”
“For any institution with leveraged bond portfolios, the capital losses from August last year of 25% to 30% on an ungeared bond portfolio simply became unbearable in September as losses accelerated.”
Even in the eventuality that bonds stabilise from here, they will still yield a negative real return in the UK, said Fourie, which isn’t the case in some emerging markets. This puts the UK in a “very unenviable position”.