David Roberts

Why I remain bearish on gilts (despite supportive data)

David Roberts

A second day of apparently weak headline UK data support gilt prices once again but I remain reluctant to invest my own cash, never mind my clients’, in this market.

Of course, all needs taken in context. UK CPI at the headline level (which, one must remember, is the Monetary Policy Committee [MPC] target) remained high yesterday, printing at 2.4%.

It was similar with retail sales this morning: we had a blowout number for the month of May and it does look as if economist estimates for June were just too high. Even with this supposed miss, the annualised rate of retail sales growth remains the second highest since the end of 2016 and at a level much of the developed world would give its eye teeth for.

We are of course in the business of trying to predict where the economy is going, not where it has come from. However, if we pause to consider, we have had a year dominated by domestic political uncertainty, plus the added tension of escalating trade wars and renewed emerging market fragility. And, yet, gilt yields are actually unchanged compared to a year ago – so at a time when inflation rose to 2.4% and the nominal economy grew about 4%, one would have made a nominal return of 1.2% owning 10 year UK gilts. In real terms, buying gilts lost you money.

Again for both Gilt bulls and the MPC, the headline “weakness” could easily be justification to be long bonds or not to raise rates.

My issue with buying the market today remains the same as it was a year ago – yields are simply too low for prevailing and forecast scenarios (probably including a further Brexit disaster).

Sterling continues to suffer in part as forecasters build in probabilities of a “no deal with Europe”. The consensus on such a scenario is a 5% fall in the sterling/dollar rate, with a range 2% to 8% (note: 8% is the same amount sterling fell in immediate aftermath of the Brexit vote). That is likely to bring a further spike to inflation, offsetting any “positive” bond story from weaker domestic consumption.

It is highly likely we will see another turbulent 12 months for all things British. It may be we see more turbulence than we have in the past year but buying gilts at a yield of 1.2% and expecting a return even in line with inflation needs volatility and uncertainty to move even higher still.

How long will investors, domestic and international, continue to support the UK economy in exchange for uneconomic levels of return? With each passing Brexit vote, the challenges for the May administration appear to grow. Political uncertainty, a falling currency and uncertain economic future can easily turn from being bond positive to negative. Ask the Argentinians or Italians.

Of course, we can always rely upon the Bank of England to restart market manipulation and buy some gilts if everyone else runs away. The IMF invited in, sterling a basket case currency, the UK an emerging market by proxy? That hasn’t happened for at least 40 years.

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Thursday, July 19, 2018, 2:40 PM