Three weeks on from Chancellor Rachel Reeves’ big first budget, there has been plenty for investment managers and economists to consider, in terms of their asset allocation strategies.
One of the sectors that’s been under particular scrutiny post-budget, is fixed income. We asked selected investment experts for their outlook on this important asset class – and find them to be cautiously optimistic about the prospects for the sector and UK gilts going forwards.
Orla Garvey, Senior Fixed Income Portfolio Manager at Federated Hermes Limited, believes that gilts look attractive on a relative basis as she explains:
“The recent UK Budget carried significant implications for UK investors. At a high level, the two key points for the market were: 1. The increase in issuance needs over the short and medium term, and, 2. Front-loaded government spending led the Office for Budget Responsibility to revise its growth and inflation forecasts upwards and in excess of the BoE forecasts at the time. Both these points were expected to some extent, the surprising part was the decision to spend upfront rather than be prudent, allow Bank of England (BoE) base rates to come down and then use the fiscal space that would have left them. No doubt this has complicated the job of the BoE; earlier this month they cut rates by 25 basis points and pushed out the timing of reaching their 2% inflation target as expected. Governor Andrew Bailey focused on the wide range of domestic and external uncertainties impacting the outlook at the moment, including the UK’s labour market, the impact of the government’s new fiscal plans, and geopolitical upheavals.
“Looking ahead, your view on the gilt market depends on whether you believe that this front-loaded spending will give growth enough of a boost to offset the impact of higher taxes. I’m sceptical and believe that market pricing of the BoE base rate is too high versus peers and that gilts look attractive on a relative basis.”
According to Huw Davies, Absolute Return Fixed Income Manager, at Jupiter Asset Management, things could have been a lot worse as he comments:
“In the aftermath of the UK Budget, media reporting has been poring over the market reaction to Rachel Reeves’ fiscal plans for the UK economy. The scale of tax increases, especially on businesses, and the extra funding for services was at the upper limit of expectations. Consequently, the market reaction and price action in Gilts has not been great, but some of the reporting has drawn parallels to the market reaction around the Truss/Kwarteng mini-budget back in 2022.
“With much having been said about the relative inflation expectations in the UK, I would like to look instead from the perspective of real yields, especially when funding the UK deficit is uppermost in investors’ minds. Chart 1 shows 30-year UK real yields relative to their US equivalent over the last five years.
“It is pretty clear that the price charged by the market for the UK to fund over 30 years has increased significantly over the last five years. It would seem that the UK still funds at a lower real yield than the US, although the comparison is not completely equivalent because UK linkers trade relative to UK RPI, which is currently at a 100 basis points premium to UK CPI. Still, the relative move in real yields is significant since the pre-Covid period.
“The Truss/Kwarteng event marks the period high in the spread and, although the recent move after the budget is significant, it is still well within the range for 2023-24. Conclusion: this wasn’t a well-received budget, but it’s not as catastrophic as some would want to paint.”
Chart 1
Source: Bloomberg
Helen Anthony, Portfolio Manager on the Global Bonds Team at Janus Henderson Investors, is also seeing some potential for gilts commenting:
“Gilts yields increased post the Budget, reflecting the additional borrowing forecast following the announcement and the expectation of increased inflation over the medium term. While the initial market reaction was negative for UK government bonds, in the subsequent days the market has continued to struggle. At face value, this appears to be a function of the US election and the lack of impetus by investors to hold large positions given the binary nature of the outcome. The UK has some of the fewest cuts priced in the market across the developed economies which makes Gilts potentially look attractive, especially when you consider headline inflation being some of the lowest, year on year, relative to the likes of the US, Japan and Australia. That said, services inflation does remain stickier in the short term and a metric the bank are heavily focused on. As we have now had both the UK budget and US elections, Gilts can now look to trade more towards economic fundamentals and given the Bank of England still view policy rates as restrictive this should potentially help put a cap on Gilt yields.”
David Lewis, Investment Manager, Independent Funds/Merlin, is also seeing good value in the bond market as well as opportunities in UK and Japanese equitiesas he says: “We have now entered a rate-cutting cycle for the major Western central banks, which has the potential to bring about a change in the investment backdrop. We have been in a relatively rare situation where the yield on longer dated bonds has been lower than for shorter dated bonds. This is unusual as one would usually expect higher returns for taking greater uncertainty in tying up capital for longer. This dynamic has recently reversed and, in the past, this change has often presaged a recession in short order. Recently this has been known as the risk of a hard landing. However, it is also arguable that this normalisation of bond markets can simply be a by-product of bond yields incorporating the likelihood of interest rate cuts, which can help us achieve a soft landing, essentially preventing a recession and creating a path to continued growth.
“Of these two potential pathways we are favouring the latter, leading us to view equities as attractive in aggregate, but we particularly like UK and Japanese equities, which we see as two of the best value opportunities in the markets as they are both somewhat cyclically exposed and could benefit from lower rates and a soft landing. In the fixed income markets, we see bonds as generally good value, offering inflation-beating yields across the board with the potential to benefit from capital appreciation as yields move down in tandem with falling interest rates, making them preferable to cash.”
According to Peder Beck-Friis, Economist at PIMCO, “After all the pre-Budget trailing, there were no big surprises in this budget. The government hiked taxes, increased investment spending, and loosened its fiscal rules. Importantly, the deficit will fall in future years — by more than two percentage points in three years — so fiscal policy will remain tight, more so than in most other developed countries. The overall gilt remit was broadly in line with expectations too.
“There are no reasons for us to question the fiscal credibility in the UK. The government intends to bring the primary deficit into a large surplus, for the first time since the early 2000s. While debt — by the conventional definition — may not fall in coming years, it is unlikely to rise dramatically either.
“We continue to like gilts. We expect the market to over time shift its attention away from fiscal to the underlying macro drivers, including softening inflation. Tight fiscal policy should weigh on growth and inflation ahead — and over time, we expect the market to price in a lower terminal rate for the Bank of England’s cutting cycle.”
Agreeing with our other experts, Shamil Gohil, fixed income portfolio manager at Fidelity International, still sees some upside for gilts saying: “While the Chancellor seems to have struck the right balance between higher tax hikes, higher spending and borrowing to invest in the economy, there are question marks around the fiscal headroom, which looks quite tight, both on the net financial debt rule and current budget surplus, even after easing the rules – overspend is certainly higher than the market expected. It helps that she has the backing of the Office of Budget Responsibility (OBR) on growth forecasts, however, it remains to be seen if the Labour government can credibly deliver on their plans, and execution risks remain high.
“In terms of implications for the Bank of England (BoE), the higher minimum wage is potentially inflationary but the government has committed to a 2% inflation target, which should be reassuring. Investment spending should address the supply side of the economy, and therefore limit the impact on inflation. As an aside, higher taxes could be punitive for the labour market / consumer demand and thus negative for growth.
“In terms of gilt issuance remit, which is what matters for yields, approximately £20bn more of issuance pencilled in, skewed to the long end, which was not expected and leading to some curve steepening. Overall, I think gilts can continue to perform here and reverse some of their cross-market underperformance, especially as the focus shifts to the US election and associated fiscal expansion there.”
