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Last week proved to be yet another week of high drama. While the UK was clearly the epicentre, the US inflation numbers mid-week also did their best to grab the market’s attention.
Global equities ended the week down 1.6% in local currency terms and a rather larger 3.1% in sterling terms due to a further recovery in the pound. Markets are now down 21% and 10% from their highs at the start of the year in local currency and sterling terms respectively.
Meanwhile, 10-year government bond yields in the US and UK rose another 0.1% or so. UK gilts remained highly volatile and lost another 1.8% over the week, bringing the losses this year for this supposedly low risk asset to just short of a staggering 30%.
In the UK, not only do we have a new Chancellor but also most of the infamous mini-budget has now been unwound. The 45p tax rate is no longer being abolished and the rise in the corporation tax rate from 19% to 25% is being reinstated. Hunt has also just announced that the cut to the basic rate of income tax will be delayed indefinitely, a host of other smaller tax cuts will be scrapped and the energy support scheme will become more targeted after April.
Altogether, these measures should save some £32bn of the £45bn of unfunded tax cuts announced by Kwarteng. While this retreat will undoubtedly help restore confidence, the fact is we are still left with a lame-duck prime minister and government for that matter.
The turmoil in the gilt market has been fuelled by the investment strategies of defined benefit pension funds which have proved unexpectedly vulnerable to the surge in yields. The Bank of England was forced to intervene but on Friday ended its main support measure which involved buying gilts.
The hope now is that the government’s various U-turns will allow some semblance of stability to be restored. Indeed, gilt yields have fallen back today and the market has scaled back its expectations for further rate hikes. It is now pricing in rates rising to a high of just over 5%, rather than to close to 6%.
The drama of the last few weeks has not fundamentally changed our view on UK equities, which have now regained the bout of underperformance triggered by the mini-budget. They still price in a lot of bad news with the price-earnings ratio down to only 8.9x, some 35% below its long-term average and 40% lower than the US. While markets generally look set to remain very volatile for a while yet, we continue to believe the UK should be one of the better performing regions when equities eventually see a sustained rebound.
Elsewhere, US inflation came in higher than expected in September. The headline rate edged down less than anticipated to 8.1% from 8.3% and the core rate rose from 6.3% to a new high of 6.6%. More surprising than the numbers themselves was the market reaction. An instant 2% fall in US equities to a key technical support level was followed swiftly by a 5% rebound which left them up 2.5% on the day, only then for this gain to be unwound a day later.
Another 0.75% rise in US rates to 3.75-4% looks all but certain on 2 November. This is all the more the case as retail sales posted an unexpected gain in September and the earnings reports of the big US banks reported on Friday showed few signs of a pronounced downturn.
Finally, we had the start of the Chinese Party Congress, which takes place every five years and should lead to the appointment of President Xi Jingping for a third five-year term. Xi’s flagship speech took a firm line on Taiwan and also suggested there will be no major early relaxation of the zero covid policy.
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