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23 June 2023
The UK’s chronic inflation headache
The UK’s latest inflation data came in above expectations yet again. We examine the country’s economic outlook for the rest of the year and the implications for fixed income investors.
Fundamentals
The latest year-on-year (YoY) inflation data for the UK released on 21 June provided another upside surprise: headline inflation for May was 8.7% YoY vs. an anticipated 8.4%. The different components reveal no specific outlier and the inflationary pressures appear to be fairly broad based. Simultaneously, the labour market remains similarly strong, with wage growth having reaccelerated over the first half of 2023. While forward-looking indicators present a mixed picture on the outlook, the country’s key issue of weak labour supply may not be resolved in the near term. Since 2020, the proportion of inactive workers has been on the rise, with mainly the older part of the population and long-term sicknesses driving this dynamic. With these headwinds, the Bank of England (BoE) is facing a particularly challenging environment as it seeks to cool inflation.
Quantitative valuations
The market acknowledges the extent of these challenges for the BoE, both in absolute terms and relative to other developed market central banks. For example, the Federal Reserve has paused on its tightening path and did not increase interest rates during the latest meeting. While the question of potential additional hikes remains, pricing suggests only marginal increases and then rate cuts in 2024. The markets’ expectation of cuts in 2024, although in varying degrees across regions, is consistent across all major developed market economies except the UK. About 150 basis points of further interest rate increases are priced into the UK market and the shape of the curve suggest that the BoE will have to keep interest rates higher for considerably longer than other central banks. These dynamics are also reflected in the valuations of UK Gilts, which appear stretched relative to US Treasuries and European government bonds, and close to levels we have seen during the liability-driven investing (LDI) crisis last year. However, given the current economic picture, we think that these levels are justified.
UK interest rates reflect a “higher-for-longer” scenario vs. other developed markets
Source: Bloomberg, J.P. Morgan Asset Management; data as of 21 June 2023. Chart displays market expectations on upcoming base rate changes for the next three years.
Technicals
The current supply and demand may be perceived as different sides of the same coin and neither seems to support favouring the UK government bond universe at this point in time. Investors are positioned long duration within their UK allocations and have continued to add to their exposure over the last month. The pickup in demand has been driven by domestic buyers and is significantly higher than long-term historic averages. However, there are doubts around the markets’ ability to absorb the upcoming supply. Expected net supply for the year of around GBP 230 billion would be more than double last year’s (less than GBP 100 billion). For perspective, both levels are considerably higher than levels we have seen over the last decade – in some years the net issuance has even been flat.
What does this mean for fixed income investors?
While valuations for UK rates may appear stretched, we remain cautious; it is difficult to argue against a higher terminal rate given the inflationary pressures the country continues to face. We prefer government bonds of countries that are further along in their monetary tightening cycles and, as such, we are long duration in other developed markets, particularly (the long end of) the US.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors
include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations
is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors
are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum
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