Market Commentary 21st October 2022

For those that don’t know, I head the investment team at IPS Capital. Each week I highlight few things that have come across my desk that I think are interesting and investment related. We always welcome dialogue so if you have any questions we’ll be happy to answer them here too.

 

I have a 1 year old niece who will have seen 4 chancellors, 3 prime ministers and 2 monarchs by next Monday. I hope things quieten down a bit for her before she starts nursery. The news I can bring you is that all the drama this week has been in Westminster and not in bond or currency markets. The appointment of Jeremy Hunt as chancellor, support from the Bank of England and the reversal of much of the mini-budget has worked to calm the waters for UK investments.

 

To illustrate this, here is the interest rate on 30 year UK government bonds compared to their US equivalent. You can see that the day before the UK mini-budget they were about the same at 3.6%. 2 days after it UK yields were over 5% with US yields still below 4%. Once it became clear the mini-budget would not stand (and with support from the Bank of England) yields have continued to fall. As it stands today, UK 30 year yields are actually 0.3% lower than in the US. The bond market rebellion against UK fiscal policy looks to be over. (By the way, the bond markets won.)

 

UK 30 year bond yields (white line) vs US 30 year yields (yellow)

Source: Bloomberg

Today’s yields make sense to us. The UK has a couple of headwinds the US does not face. First, as we wrote last week, we think around 44% of the UK mortgage market is either floating rate or fixed for 2 years or less. US mortgages, on the other hand, tend to be 30 year fixed rate. The impact of rising interest rates will therefore be felt by more people, and faster, over here than in the US. Secondly, like the rest of Europe, the UK has to contend with the energy price shock from the ending of Russian gas supplies. The US is (more or less) energy independent.

This means we think a recession will come harder and faster in the UK. As the chart below shows, the Bank of England plans to raise rates to 5% in by May next year. We think this will do the job of causing the recession that brings down inflation. Then we should see interest rates (especially shorter dated ones) fall again. This makes shorter dated bonds look like a good investment to us and we have been adding them to our portfolios.

UK Base Rates (far right column) are forecast to rise to over 5% by May next year

Source: Bloomberg

Apart from this investment opportunity, what other good news can we give you? First, there is some positive news on energy. Businesses and consumers have cut their usage, storage is full and so far we have had a very mild autumn. This all means UK gas prices are now back below where they were before Russia invaded the Ukraine. There are some obvious caveats here: the lack of Russian energy is a long term problem, not just for this October. Also, the weather won’t stay this mild all winter. That said, today’s energy prices are below the UK’s energy cap. At least, and I speak as a taxpayer, the government energy price cap is not costing the government much so far this winter.

UK Gas prices are back below where they started the year

One rule of commodities is that the best cure for high prices is high prices. The cutting off of Russian gas is forcing us to be more efficient and spurring investment in renewable energy supplies like solar and wind. In the long run, this will prove to be a blessing for the UK and Europe. I would never bet against human ingenuity. In the short run, the news flow inevitably focusses on the drama and the bad. This means you can often miss longer term progress. To finish, here is the cost of producing 1 lumen of light since the 1300s. As it grows dark again this winter it is worth remembering that for much of human history light at night was a luxury available only to the very rich. Renewable energy technology has been improving rapidly in the last few years. The actions of Vladimir Putin will only make this continue.

Chris Brown
CIO
IPS Capital
cbrown@ipscap.com

 

The value of investments may fall as well as rise and you may not get back all capital invested. Past Performance is not a guide to future performance and should not be relied upon. Nothing in this market commentary should be read as or constitutes investment advice.