What a week, what a month, what a year.  The term ‘unprecedented times’ is used a lot and whilst you can argue that we’ve had wars, high inflation, weak sterling and political uncertainty before, the severity of investment market falls across asset class is unusual, if not quite unprecedented.  The last time the US equity and bond market both fell in a calendar year was 1967 and it’s only happened one other year, in 1931 (data since 1926).  It looks like 2022 might be joining the rare list.  The stress this week was dominated by problems at home, here in the UK.

The ’mini-budget’ was anything but mini and highlighted the lack of cohesion between monetary and fiscal policy.  The Bank of England has been trying all year to reduce demand by increasing interest rates (woefully too late and slow).  The new Government then announce two policies in a week; the first is to cap energy prices for two years and the second to reduce taxes.  The first is necessary and effectively caps energy inflation for the next twelve months to zero, which is roughly half of the 9% or so inflation we’re seeing at present.  This would be music to the Bank of England’s ears.  It won’t give consumers more money to put in their pockets, but it won’t be as horrendous for disposable income as we feared and gives some certainty.  It comes at a potential huge cost to borrowing and ultimately the taxpayer.  The second announcement around the ‘mini-budget’ has been well documented and has caused chaos in investment markets. 

Last week, the cost of borrowing in sterling for the UK government was roughly 2% per annum for a two-year term.  This week, it has jumped to 4.5%.  This has huge implications for the economy and investment markets; we’ve seen interest-rate sensitive assets sell-off sharply.  Whilst a two-year interest at 4.5% causes some concern, it’s the speed of the move and the uncertainty around future interest rates that is causing the distress.  We’ve heard estimates that interest rates might go up to 6.5% by the start of next year.  Every asset has been repriced downwards to accommodate this.  It almost doesn’t really matter what the Bank of England does in respect of rates now as longer-term interest rates have already moved, it’s already happened. 

So, what about the future?  The potential positives from the mini-budget have been completely undone by the market reaction.  The cost of re-mortgaging your home will now be far higher than the benefit of a 1% income tax cut.  We don’t think the Bank of England will get to 6% interest rates.  The Bank has been raising interest rates to try and reduce demand.  The reaction to the mini-budget will reduce demand, without the need to raise interest rates.  They will raise interest rates, as sterling would fall a lot if they didn’t, however we now think it is a matter of time before they must start cutting interest rates to help support demand.  By the end of next year we can see inflation being below their 2% target. 

This means that whilst the economic outlook is at best uncertain for the UK in the next six-months or so, the huge increase in interest rates means the outlook for investing from here looks a lot more interesting.  If investors can receive 4.5% a year from a so called ‘risk-free’ asset, that is the minimum expected return from all UK assets.  We haven’t seen that level of potential return for a decade.  If UK government bonds will return 4.5% a year, then risk assets, such as commercial property, infrastructure and corporate bonds will return more like 5.5-7%.  The Bank of England expect inflation to be around 4% a year for the next three years (before the energy price cap announcement).  Therefore, investors won’t have to take as much risk to beat inflation over the next three to five years.  That time-scale is important.  We’re not saying that assets will bounce back next week, investors will have to be patient but the potential is huge.

It’s important to look forward and learn from the past.  If you have a long-term time horizon and the capacity to take on risk, now looks like an interesting time to take advantage of the weakness in UK assets.

Thanks for reading.