From recovery to stagflation: how the war reshaped the UK outlook

This article explains how the UK’s improving economic outlook has been disrupted, with the war bringing renewed inflation pressures and slower growth. It then takes a detailed look at the implications for Netwealth portfolios.

Before the war, UK inflation appeared on course to fall back towards the two percent target within months. Lower interest rates and bond yields would likely have followed, supporting real incomes and allowing modest growth to return. The economy would still have faced headwinds, not least from higher National Insurance and minimum wages weighing on employment, but the overall direction was improving.

The war changed the UK outlook. What had been shaping up as low inflation and modest growth has instead become stagnation and renewed inflationary pressures: stagflation.

Overall the economic outlook remains heavily impacted by the war and by how high energy prices remain.

Policy makers are able to outline different scenarios - as was unveiled at the recent Bank of England policy meeting - but markets do not have that luxury. They have to weigh up all the different moving parts. The gilt market has opted to take a cautious view.

The key relationship is between growth and interest rates. Before the conflict that dynamic was beginning to improve. Now it has deteriorated. Even if the war ends soon, there will be an adverse impact on inflation and growth.  While the government’s debt position is poor, personal and corporate balance sheets may be sufficiently robust to provide some economic resilience.

In comparing bond yields across countries, policy rates matter enormously. The European Central Bank (ECB) had been able to cut rates more aggressively in recent years, helping euro area borrowing costs settle at lower levels. On the eve of the war Britain looked poised to begin catching up.

Since the war bond yields have risen across the board, particularly across the UK and western Europe as central banks with a single mandate to control inflation - such as the ECB and the Bank of England - are now seen as more likely to raise policy rates.

Britain’s borrowing costs are higher than elsewhere, reflecting a risk premium because of sticky inflation and the poor fiscal position.

The market has already discounted much bad news. It has gone from pricing in policy rate cuts before the war, to now anticipating hikes. This already amounts to a tightening as credit conditions have already tightened in recent months. But a rate hike this summer is still possible if the Bank believes inflation pressures will persist.

Political uncertainty about a possible change in Prime Minister - and in turn a likely change in Chancellor - is not helping. But even if there was to be no change in policy either with the current or with a new PM, the risk premium would remain, as the markets are not convinced that the current policy stance will address the mounting debt challenge. A shift leftwards to a more relaxed fiscal stance would exacerbate market worries about the debt and rate outlook.

Portfolio implications

Netwealth portfolios hold a balance of gilts and US Treasury bonds foremost as protection against potential slowdowns in economic growth, and also to contribute to returns through the income generated by healthy running yields. The US allocation is held in Treasury Inflation-Protected Securities (known as TIPS) and this has been helpful in the reinflationary episode since the onset of conflict in the Middle East. The recent uplift in US inflation in April to 3.8% annual rate impacted bond markets globally this week, and the US Treasury had to offer a 5% coupon for new 30 year debt for the first time since 2007. TIPS however have proven resilient, with a steady 2% post-inflation yield. Portfolio allocations to commodities have benefited from the energy spike, but holding TIPS has also provided some support.

Gilts have suffered in this economic and political environment. The market has discounted a lot of negative news and yields are now at a high level as investors are appearing to demand more compensation for their embedded risks. We still find corporate exposure unattractive, given its sensitivity to any equity market sell-off.

Our view had been that yields were attractive enough given known risks to sovereign fragility, and set at a level where future returns would be strong if growth faltered. After a good start to the year, gilts have been hit hard by the war and subsequent political mess. We see their many risks, and continue to closely monitor so that our bond exposure is fully in sync with portfolio goals.