UK assets were under the spotlight last week, against the backdrop of Friday’s “fiscal event”, announced by the Truss government. The mini budget was certainly brave, time will tell whether it was foolish or not, but markets voted clearly and quickly: gilts and sterling fell very sharply.
Understandably, there has been much coverage about the detail of the mini budget and the pros and cons in the shorter and longer term. We don’t want to repeat that here. Instead, we want to zoom out and put it into a global context, both in terms of the broader global environment and also in terms of constructing global multi asset portfolios.
One of the main characteristics of the global environment more recently has been higher rates, driven by the US Federal Reserve, in an attempt to contain inflation. Previous to this environment, we had an extended period of extremely low rates and quantitative easing, which supported the weak, both at an economic level and the financial assets representing those economies.
Higher inflation, higher rates, quantitative tightening and a stronger US dollar are not only removing those artificial supports, they are chipping away at the foundations of the weaker economies and their financial assets, especially those countries that have to import energy.
In those economies facing a stagflationary environment, politicians, especially short term populists, are increasingly focusing on growth through expansive fiscal policy, while central banks are focusing on containing inflation, through tighter monetary policy. This policy tension is doing nothing for the credibility of central banks, or their independence, and is reflected in the behaviour of those countries’ financial assets.
Last week saw the focus fall onto UK assets but this environment is not specific to the UK, although it might feel like it if you have a UK centric portfolio. It is about risk assets generally, which brings us to the second point, about constructing global portfolios.
Going back to first principles, what is risk? It’s certainly not a static concept. For example, UK government bonds (7 to 10 years), only recently considered to be a safe haven asset, are down around 30% year to date. Meanwhile sterling isn’t behaving like a typical developed market currency either: falling when rates go up is more typical of an emerging market currency. Neither is risk static from a relative risk perspective: not only are gilts losing a lot of absolute value, they aren’t moving in a different direction to equities.
As always, but now more than ever, portfolio construction needs to be fluid, and avoid dogmatic assumptions around asset class behaviour. Moreover, more than usual, it needs to be ready for the unusual. For example, interventions are increasingly likely, see how the Japanese authorities intervened in currency markets last week, for the first time since 1998. Emergency rate hikes ahead of scheduled meetings might become more likely and no doubt well-flagged quantitative tightening will come under pressure to be stopped too.
Those investors following a static model-based approach to portfolio construction will have seen their low-risk funds exhibiting high level losses this year. Indeed, if you have a UK dominated portfolio, last week will have been felt just as much by the “miners”, as by the canary.
For us, we have relatively little sterling, gilts or domestic UK equity. Indeed, we are more concerned about the degree to which last week’s events are contagious to other assets globally. In that context, we believe that as long as US rates continue to rise, so assets will struggle, particularly the weaker ones.