What you need to know
- UK Prime Minister, Liz Truss, on 23 September unveiled drastic fiscal stimulus and tax cuts to support consumers through the cost-of-living crisis
- Markets have taken this – unfunded – ‘mini’ budget negatively, as it significantly increase government borrowing and may further raise domestic inflationary pressures
- The pound sterling reached an all-time low vs the US dollar at near parity. A weak pound has been positive for sterling investors holding unhedged foreign exposure
- 10-year UK gilt yields also rose sharply to 4.5%, a level last seen in 2008, and a sharp rise from 1% at the start of 2022, though the Bank of England is currently intervening to stabilise the rates market
- The recent events have shown the benefits of globally diversified portfolios, as we typically carry low single digit exposure to UK domestic assets (such as gilts) and hold notable foreign exchange exposure such as the US Dollar
- We maintain this positioning and, in this piece, analyse what this means for your portfolio
Pound and gilts take another hit – but remain unattractive
The UK released a
‘mini’ budget highlighting an important shift in policy towards lower taxation, with more tax cuts planned for 2023. As this budget will need to be financed by issuing gilts when interest rates are rising (+215) bps since the start of December 2021), government borrowing needs/costs will rise sharply, for several reasons. First, the UK plans to spend another GBP 60 billion, ~2.5% of GDP, on subsidising energy bills for the next six months. The UK Debt Management Office increased its planned bond sales for the 2022-23 fiscal year by GBP 62.4 billion to GBP 193.9 billion (+210%).
Second, to limit currency weakness, the Bank of England will likely raise rates further. A further depreciation of the pound could increase the import bill, at a time when UK FX reserves are declining, accounting for 1.8 months of imports in June 2022. This could be another headwind for the pound. We have revised lower our pound sterling end-2022 forecast to USD 1.00/GBP, to account for a worsening fundamental outlook.
Gilts have sold off since 22 September, with gilt yields rising across all maturities by ~100 bps in a matter of days. We believe gilts are unlikely to peak in the very near term, despite the Bank of England’s (BoE) temporary measures announced on 28 September. The BoE is attempting to stabilise long-dated gilt yields and, by implication the mortgage market, via temporary purchases. While this is likely to help further down the line, we don’t believe it will be sufficient to compensate for the high government borrowing and inflation expected and we therefore keep low single digit exposure to gilts in our model portfolios. Instead, we maintain a tilt towards overseas corporate bonds and Emerging Market bonds.
Foreign exchange (FX) in GBP portfolios a tailwind
Investments can be made in different parts of the world and, as a result, in different currencies. However, every investor typically has a base currency, i.e. the currency in which the portfolio is priced. It’s usually the pound sterling for UK-based investors or the euro for clients based in the euro area.
The global nature of our model portfolios means they include investments in assets denominated in different currencies. That is intentional. We are seeking to harvest returns in every part of the world, which also ensures broad portfolio diversification. The biggest foreign exchange exposures in both GBP and EUR portfolios are to the US Dollar, followed by emerging market currencies, and the Yen.
Fluctuations in the exchange rate between assets held in a foreign currency and the base currency of the portfolio can then add or subtract from the return and risk of the portfolio if left unhedged. For assets whose returns are typically lower or less volatile, such as fixed income returns, the volatility of FX exposure can have a large impact. That’s why we typically hedge the foreign exposure of foreign fixed income assets held in our model portfolios.
Generally speaking for our model portfolios, lower risk profiles, which comprise larger exposure to fixed income, carry less FX exposure than higher risk profiles where equity risk is the dominant factor. Lower risk portfolios, therefore, typically hold around 70% in the portfolio’s base currency. Instead, balanced mandates and riskier equity portfolios hold over 50% in FX. Such FX exposure has been beneficial to portfolios in the recent pound sterling weakness and we continue to believe in the structural diversification benefits they provide.
We maintain a positive tactical view on the US dollar
We expect the greenback to stay strong over the short term, before moderating over the medium term. Recent macro/policy developments and market moves have led us to revise our forecasts lower for both the pound sterling and the euro, and mechanically higher for the USD.
The US dollar benefits from:
- a relatively resilient economic outlook in the near term relative to the euro area and the UK, although in an absolute sense also the US is weakening
- a more hawkish Fed vs the European Central Bank and the BoE
- persistent global risk aversion
These factors matter more at this stage than the fact that the dollar looks overvalued, overbought, and positioning being still long. The Fed remains in ‘combat mode’ against inflation, even if growth continues to weaken. The market is expecting another 75 bps Fed rate hike in November, and more thereafter, albeit at a slower pace (50 bps in December), a view that we share. Interest rates are expected to peak at around 4.50-4.75% by mid-2023.
To see the USD peaking, we’d need to crest three other peaks: peak US inflation (in progress), peak Fed rhetoric (not yet) and peak Fed action (not yet).
To conclude & what we are watching
Recent events in the UK highlight the risk of fiscal slippages that may broaden to other countries, such as those in the euro area. This is a complex backdrop where central banks are trying to combat inflation by lowering demand, whilst governments are tempted to boost demand as they seek to help consumers fight against the cost-of-living crisis. All this in a challenging geopolitical environment, which we are watching very closely given recent developments related to the Russia/Ukraine war.
