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11/11/2016

Taking stock

October was the worst monthly performance of the year for the UK government’s bonds

In October, the FTSE 100 was up by 0.8%, significantly outperforming 7-to-10 year UK gilts, which were down 3.4%. It was the worst monthly performance of the year for the UK government’s bonds. More saliently, as of the end of October, the year-to-date performance of the FTSE 100 (11.4%) beat that of the 7-to-10 year gilt index (7.3%), the first time that has occurred in 2016 (see figure 1). Two months ago, the two performance figures were nearly reversed. For most of the year, it hasn’t even been close.

A major driver in shifting fortunes for both indices has been the plummeting pound. By any standard, October was a bloodbath: Sterling was the worst-performing of 150 global currencies versus the US dollar. This directly led to October’s “performance switch” between Gilts and equities in regards to which has been the better investment over the year so far. However, October is not a one-off. Following the EU referendum result in late June, the pound is the worst-performing major currency in the world, down approximately 20% versus the US dollar. This coincides with the period where the FTSE began to close the YTD performance gap versus Gilts. It is not a coincidence.

What’s going on?

There are two closely related forces being exerted on each asset class, but with vastly different outcomes. The first is simply the weakness in currency, and what that means from an accounting perspective. The second involves inflation expectations, which are rising as a weak currency implies the cost of imports will rise. The UK is particularly sensitive to the second factor given its significant trade imbalance.

First, the weak currency has amplified the repatriated earnings of multi-national companies based in the UK, providing significant support to the FTSE 100. In essence, this is an accounting effect, but certainly does make globally-oriented firms appear to be more profitable in their base reporting currency. Second, the relatively healthy yields for UK equities – compared to other equity indices or asset classes – has always made them attractive for income investors. With increased inflation expected, these dividends are even more sought after as they tend to be reasonably resilient to inflation over the long-run. 

Conversely, 10-year gilt yields have nearly doubled from 0.65% at the start of October, to 1.25% at the end. Higher inflation is akin to the plague for conventional bonds, as it diminishes the value of fixed future coupon income. While government bonds globally are selling off given an increasing likelihood of US rate hikes and less quantitative easing from key central banks, the inflationary headwinds in the UK makes the losses suffered by gilts significantly more acute than those experienced by equivalent US treasuries or German bunds.

Pound

Calling the direction of foreign exchange market is notoriously difficult, particularly when volatility is elevated. Nonetheless, we are reasonably sanguine on the prospects for Sterling, particularly versus the US dollar. The reasons are twofold. One, the plummeting value of the pound has resulted in it being significantly undervalued on a purchasing power parity basis. Second, the relative momentum of rates between the two major currencies appears to have tilted back in favour of Sterling. While markets have long priced in a rate hike by the US Federal Reserve in December, expectations of a near-term rate cut in the UK have sharply diminished given steady UK GDP growth and a jump in inflation expectations.

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