Stocks have largely flown under the radar over the past ten days, as attention has turned to the fallout in the currency and bond markets following Kwasi Kwarteng’s mini-budget.
Sterling dropped to an all-time low against the US dollar before staging a rebound, while gilt yields temporarily soared to 4.5 per cent, making government borrowing even more expensive.
The Bank of England was forced to step in and buy long-dated bonds to ‘restore orderly market conditions’ in the mini-budget aftermath.
Sterling has since recovered and is currently at $1.12 against the Dollar, while five year and 10 year gilt yields are trading at 4.2 per cent.
The stormy waters have calmed somewhat, but ratings agency Fitch has now downgraded UK debt – and the FTSE 100 is back knocking around 7,000. So, what does the current situation mean for UK investors and how defensive or adventurous should they be?
Gilt trip: The stock market is feeling the effect of the crisis in the bond market and the fall of the pound versus the dollar
What has happened to the stock market?
The stock market has in the past been a a good barometer of the general economic health of a country.
The FTSE 100 and FTSE 250, however, have told two opposing stories about how well the UK has dealt with the looming threat of ever-rising inflation and interest rates.
The FTSE 100 has performed relatively well this year – it is down around 6.5 per cent while the S&P 500 is down 21 per cent following a tech rout.
This has come as the Footsie has been buoyed by its large mega-cap companies with positive exposure to the factors causing the global economy problems, for example energy firms Shell and BP.
But the UK stock market only represents around 4 per cent of the global market, whereas the US represents almost 60 per cent – so share price falls there will have caused serious dents to portfolios.
However, sterling’s decline has softened that blow for UK-based investors
The S&P 500 is down in dollars bya fifth but only down about 3.5 per cent in sterling terms.
Jason Hollands, managing director of Bestinvest said: ‘At a time when the news is leading on the battering of UK assets, this is a reminder that UK large cap equities have actually been very resilient.’
The blue-chip index has been well protected against the falling pound too given two thirds of the FTSE 100’s constituents’ sales come from abroad.
A large proportion of that revenue is denominated in dollars meaning the 20 per cent fall in the value of sterling has given these companies a boost.
The FTSE 100 has dropped over the past month but recovered some ground since its lows
The make-up of the FTSE 100 also helps to insulate the index from the worst of the volatility.
It is home to the UK’s largest companies which are largely in defensive sectors, such as pharmaceuticals and utilities.
Oil majors have also performed well following the Ukraine invasion in February which has pushed prices up. Shell and BP are up 34 per cent and 30 per cent, respectively, in the year-to-date.
But it isn’t all good news. Stocks that are more exposed to consumers or the UK economy have taken a beating.
Retailers, who have shaken off the impact of the pandemic, are continuing to feel the effect of rising inflation and some big names have seen share prices suffer.
Next, which is seen as a bellwether of the high street and one of its most robust names, cut its full-year guidance last week and its shares are down 41 per cent this year. Meanwhile, M&S, which many had considered to be on the cusp of a recovery at the strat of the year is down 59 per cent.
Fast fashion stars Asos and Boohoo have had a period of even more dire performance, losing 75 per cent and 68 per cent, respectively, this year.
The FTSE 100’s 20 biggest fallers over the past month have suffered 16%-plus declines
‘The fact that many retailers are struggling shouldn’t be a surprise. This is arguably the most difficult trading environment since the 2008/09 financial crisis,’ says Charlie Huggins, head of equities at Wealth Club.
‘Inflation is at levels not seen for four decades. Sterling is in the doldrums, trading at its weakest level against the dollar since 1985. Add to this, the war in Ukraine and the spectre of further interest rate rises. It’s not exactly conducive to consumers restocking their wardrobes.
‘Perhaps the biggest issue for the whole sector is that while things look challenging right now, they look set to become even more so. This is due to the precipitous decline in sterling which will only exacerbate inflationary pressures.’
Similarly the more domestically-focused FTSE 250 has not performed as strongly, because the constituents make a large proportion of their profits from the UK, so it is more sensitive to weaker sterling. It has shed 26 per cent since January.
Hollands notes that the UK is far from alone in dealing with the turbulence of markets as they react to what they see as increasingly aggressive actions taken by central banks.
‘Although dollar exposure through overseas investments has helped UK investors out, no one should be under the impression though that the world beyond the UK is an oasis of calm,’ says Hollands.
What do rising gilt yields mean for shares?
A rise in gilt yields means the yield premium offered by equities has narrowed and Hollands says is on the cusp of closing.
For example, if someone can get a ‘risk-free’ annual rate of return of 4 per cent from a five-year gilt, but the expected dividend return from holding shares is also 4 per cent, they have little incentive to opt for the second riskier asset.
Hollands says: ‘This should not be regarded as a red flag per se, as prior to the global financial crisis bonds often yield more than equities, but it is a headwind of sorts.’
Income seekers have had little elsewhere to turn other than equities for over a decade, but they will have more options now bond yields are rising.
Yet, Hollands warns investors to be careful as if yields continue rising, bond prices will fall even further.
‘Historically equities have been the key driver of returns in portfolios, with bonds used as a stabilising influence to reduce volatility in tougher times.
‘The unwinding of a decade of ultra-low interest rates and periodic monetary stimulus programmes – involving central banks buying vast amounts of bonds – has put a spanner in the works, with both bond and equity markets declining in tandem this year. Such a synchronised decline is rare.’
Government bonds have tended to be a relatively low risk investment because governments of major economies, such as the US and UK, are unlikely to default. But volatility in prices must be factored in, unless bonds are held to maturity.
Hollands adds: ‘Prior to the global financial crisis, bonds routinely yielded more than equities, so this is not a reason in itself for investors to panic. Equities have the scope to grow dividends over time, which bonds do not.
‘However, it does signal the end of a long period when income investors had few alternatives to moving up the risk spectrum in the search for income by investing in equities, making equities a no brainer. This is therefore a bit of a headwind for equities.’
The FTSE 100’s 20 best performers over the past month shows how for some shares just about keeping their heads above water was enough to get in the list
Gilts and yields explained
Gilts are the term given to UK government bonds. Government bonds are IOUs issued by countries as a way of financing their economy.
They are issued over different lengths, for example 2, 5 or 10 years, and pay investors a set rate of interest – known as a coupon – plus the bond’s face value back at the end of the term, known as maturity.
For example, a £1,000 five-year gilt issued at 4 per cent would pay an investor £40 in interest every year, plus the original £1,000 face value back at the end of the five years.
Bonds also trade on secondary markets and the price there may be above or below the face value depending on demand.
Bond yields measure the interest rate return an investor would get for buying a bond at the price it is trading at: if a bond’s price falls, its yield rises as investors are purchasing a set amount of interest at a lower price.
For example, a £1,000 face value bond with a 2 per cent coupon would pay £20 a year, a yield of 2 per cent.
If this falls out of favour and trades at just £500, the yield would have risen to 4 per cent, because investors can buy £20 of annual interest payments for just £500.
Rising bond yields on the secondary market have an impact on new debt that is issued, as unless new bonds match the returns on second-hand bonds investors may choose not to buy them.
Will the Bank of England’s actions affect investors?
On the day the Bank of England stepped in, some sectors heavily hit by expectations that gilt yields, borrowing costs and interest rates would keep rising benefitted.
‘Many more UK stocks turned positive on the day with housebuilders like Land Securities, Berkeley Group, Barratt Development and British Land outperforming at the top of the UK index thanks to the bond market rally and corresponding fall in yields,’ said Victoria Scholar, head of investment at interactive investor.
‘Conversely, the pullback in yields is weighting on stocks in the banking sector like Barclays and Standard Chartered as well as insurance companies like Legal & General and Aviva which benefit from higher yields.’
The Bank’s intervention has brought some welcome stability and prevent a run on the gilt market, but it won’t be a source of comfort for long.
Donald Phillips, co-head of the Liontrust Global Fixed Income Team said: ‘Ultimately, whilst inflation remains a problem, quantitative easing is unlikely to be anything other than a very short-term fix. Indeed, the Bank is clear that quantitative tightening will recommence at the end of October.’
And an unexpected intervention suggests the Bank is nervous about the ‘dysfunction’ in gilt markets which will do little to calm markets.
Increasing something that looks like quantitative easing – although technically many argue it isn’t – just a week after announcing a tightening of policy doesn’t help the Bank, or the Treasury’s credibility.
All of this adds to the potential volatility for sectors struggling with rate rises, such as housebuilders and consumer-focussed stocks.
Monetary and fiscal policy have largely been at odds with each other but now the Bank of England is being forced to counterbalance the PM’s plan for growth.
A hike in interest rates ahead of the November MPC meeting is unlikely, for now, but rate raises are coming and the market has already priced in a peak for base rate of 5 and 6 per cent, which along with disruption in the gilt markets has thrown the mortgage market into disarray.
The Bank of England’s short-term plan was broadly welcomed by the market to restore the bond market but it could well add to inflationary pressures, making the situation even worse.
Ultimately, volatility looks like the order of the day for some time to come but long-term investors are urged to stick to their guns and continue to regularly invest if they fear the consequences of sudden sharp drops for lump sums.
Myron Jobson, of Interactive Investor, said: ‘The current environment is a stark reminder of the need for discipline and patience when it comes to investing. Drip-feeding cash into investments helps to lower investment risk, smoothing out the inevitable bumps in the market by buying fewer shares when prices are high and more when prices are low – a process known as pound-cost averaging.’
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