Where do fixed income investors go from here?
Since Friday’s ‘mini-budget’ from the UK Chancellor, Kwasi Kwarteng, and his subsequent comments to the media over the weekend, we have seen catastrophic moves in both sterling and Gilts.
Despite some of the measures announced being anticipated and pro-growth, there was more fiscal stimulus than expected (at loggerheads with the monetary policy adopted by the Bank of England) and market participants were also left with a few questions regarding how the funding part of the equation will work.
Without going into the detail of the announcements, we think it is worth analysing which parts of the UK economy might be affected if these trends continue. We highlight though that if the government were to provide a clearer path for addressing the aforementioned funding concerns, these trends might reverse, at least partially, relatively quickly.
The summary of the UK market reaction is higher rates across the curve and a weaker currency. Credit spreads widened and equities were down as well, but here the moves were of a similar magnitude to those we saw in the equivalent dollar and euro markets. Regarding macro projections, people now expect slightly higher growth in the short term for the UK along with higher terminal rates.
A higher rates environment – provided rates don’t climb to levels that cause a major increase in default rates and non-performing loans – is helpful for banks and life insurance companies. Deposit costs for banks have not climbed as fast as monetary policy rates might suggest, and this will be reflected in stronger net interest margins (NIM). This phenomenon is not exclusive to the UK, and it is largely a by-product of the huge increase in deposits in the economy in the aftermath of COVID-related fiscal packages. Banks are in no rush to compete for deposits, while at the same time longer tenures have seen meaningful adjustments. This translates into higher rates for mortgages, corporate loans and other banking products, while funding costs do not increase as rapidly, resulting in higher NIM for banks. Regarding NPLs, this remains well under control and our assessment after discussing the topic with banks management teams is for these not to increase dramatically. This is consistent with banks’ own projections. Even if said projections turn out to be optimistic, as credit investors we are comforted by the very high capitalisation levels UK banks exhibit. If we look at life insurers, higher rates reduce the reinvestment risk they carry on the asset side of their balance sheets. In addition, products with guarantees are cheaper to issue when rates are higher. Finally Solvency II ratios and other capitalisation metrics for these companies are positively correlated with higher rates.
Regarding currency depreciation, those who have unhedged debt in foreign currencies and/or have inputs in foreign currency with no pass-through provisions or poor pricing power stand to lose. UK high yield issuers sometimes issue debt in euros (very little in dollars). Our understanding is that for the most part this is hedged either through derivatives or by having operations and assets in euros. In any case, while GBP is down 20.30% year-to-date against the dollar, the euro is down 15.50% over the same period, so the impact should be relatively small if there was one. Companies that have costs denominated in foreign currency and GBP denominated revenues, with little pricing power, are mostly in the retail space, a sector we would stay clear of not only because of currency considerations. On the other hand, global companies based in the UK with assets denominated in foreign currencies could see the value of those assets increase. A lot will have to do with hedging and accounting but it is quite possible that the capitalisation of some of these companies improves as a result. This is part of the reason why the FTSE 100 has outperformed this year given the high weight that global companies have in the index.
The biggest impact over the past two trading days has understandably been in the currency and rates markets. We think a good part of the negative reaction might have to do not necessarily with the specific measures that were announced, but rather with the lack of clarity as to how these will be financed. This could be addressed in the coming weeks. Without a doubt some companies will be worse off as a result of a weaker currency and higher rates, but a careful bottom-up analysis is very important. Global companies in an open economy, some of which are actually levered to higher rates, might actually perform well.