While the gilt market performed well late last year, post-election optimism may be leading investors to overlook risks to the UK economy in 2020, argues Sunil Krishnan. Were they to materialise, gilts could outperform other global government bonds.
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While the UK economy has followed a relatively clear trend for some time, investors’ attitude to gilts has been more volatile. To reflect this, we took a contrarian approach to crowd sentiment in 2019.
Figure 1: UK real GDP
Last summer, gilts were popular because of concerns over a no-deal exit from the European Union (EU) and the implications this would have for the health of the economy. We were more negative on gilts than consensus through the autumn, and preferred other global government bond markets, as the degree of premium investors had to pay to own gilts seemed hard to justify. This came into sharp focus in October, when it became clear the Johnson government was keen to avoid a no-deal outcome. We felt this was not recognised quickly enough by investors: moves in the fourth quarter validated our thesis to some extent.
Figure 2: 10-year government-bond yields, difference UK/US
In contrast, we have now reached a stage where commentary from the government is naturally upbeat, which has created expectations of significant fiscal stimulus and potentially led investors to discount some of the risks we see to the UK economy. For instance, as of 27 January 2020, Bloomberg reported economists’ consensus for government spending in 2020/2021 had risen from 1.7 per cent/ 1.7 per cent year-on-year to 2.1 per cent/ 2.4 per cent year-on-year since August. This could lead gilt markets to outperform in 2020.
One risk is the materiality of any stimulus. Past experience has shown that, even for governments with large majorities, the early part of the governing term is not necessarily a time to be generous. In fact, tougher messages are sometimes easier to land. The Conservative party attaches much political and strategic electoral weight to being seen as the party of fiscal prudence, so while we expect to see an expansionary budget in March, it may not deliver as much as some investors expect.
The second risk is the current trend of extremely weak economic activity. While it would be tempting to ascribe it all to pre-election uncertainty, some emerging data points include surveys conducted after the election. In these, investment intentions remain weak and the inflation outlook continues to look dim. As a result, investors have unsurprisingly moved to price in a greater than 70 per cent chance of the Bank of England cutting rates by the end of the first quarter.1
In light of this, a rate-cutting cycle may well simply be a matter of time. If it isn’t delivered at the next Monetary Policy Committee meeting, it will remain in investors’ expectations. In addition, investors typically discount more than one cut at a time, so it would not be surprising to see them begin to price in a cycle of more than one cut for the rest of the year. This would, in turn, create scope for the gilt market to outperform other bond markets.
On top of these factors are potential risks arising from Brexit. Two in particular could pose a challenge to the UK economy, and therefore support gilts.
The first is if the desired deal cannot be achieved in the time available. While governments are always at liberty to water down their commitments, abandoning this one by extending negotiations would come with a price tag. Delays would force the UK to make additional payments into the EU budget until its final exit date. Even if a deal is agreed in the time available, the second risk is that it will likely cover a narrower set of issues than it otherwise could and default to global rules on the rest. Significant parts of the UK economy, particularly in services, could lose out in such a scenario.
