Written by Ilaria Massei
Last week, the UK bond market made headlines again, reminiscent of the aftermath of the 2022 Autumn Budget under former Prime Minister Liz Truss. Rising concerns over persistent inflation, sluggish economic growth, and increasing government borrowing drove bond investors to demand higher interest rates to buy gilts, leading to a -1.7% decline in the Bloomberg Sterling Aggregate Index as UK bond prices fell.
Pension funds and other Liability Driven Investment (LDI) companies were better prepared this time to manage bond market volatility, with stronger liquidity buffers to avoid the same level of distress seen in 2022. Nevertheless, inflation remains elevated, and the UK economy is grappling with slow growth. This leaves the Bank of England in a challenging position, as it must navigate the delicate balance of setting interest rates that can avoid a prolonged period of stagflation, which is the condition of an economy with high inflation and low economic growth. Higher borrowing costs also feed back into a deteriorating fiscal profile, and there is a growing sense that the Labour government will be forced to renege on its promise not to raise taxes further, given the high sensitivity around additional borrowing and cuts to public spending.
A weaker economic outlook led to a further decline in the Pound last week, which could increase import costs if the trend persists. On the bright side, the FTSE 100, whose components are large multinational companies that earn a lot of their profits overseas, rose by +0.3% as their overseas revenues are boosted by a weaker GBP. In addition, UK banks, which make up a substantial part of the index, generally benefit from higher interest rates, although concerns about long-term sustainability have emerged as loan demand could weaken due to rising costs for borrowers. It was notable that the prices of more domestic and economically sensitive mid-sized companies fared less well, with the FTSE 250 index down over 4.0% for the week.
On the other side of the Atlantic, the US economy continues to demonstrate positive growth momentum, surpassing market expectations by adding 256,000 jobs in December. This, coupled with an unemployment rate below expectation at 4.1% was perceived as positive news for the US but it’s important to remember that monthly data like this can be volatile and in recent history has been subject to record downward revisions, so it may not always be indicative of the longer-term trajectory.
If the strength of the labour market is confirmed in the coming months, the Federal Reserve may be forced to maintain high interest rates to prevent a re-acceleration of inflation. This prospect led US equities to give back some gains, with small-cap stocks taking the hardest hit. The Russell 2000 dropped by -2.1%, as small businesses are more vulnerable to the pressures of persistent high borrowing costs.
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