United Kingdom
We speak to David Hooker, Senior Portfolio Manager and lead manager on our flagship UK bond strategies, about the outlook for the UK and UK fixed income assets.
What are the key highlights of Labours first budget in this new parliament?
The Labour government, under Chancellor Rachel Reeves, has introduced a new fiscal mandate aiming to have the current budget in surplus by 2029-2030 and maintain it thereafter. The new fiscal framework expands the measurement of net debt to include public sector net financial liabilities (PSNFL), significantly reducing the UK's debt-to-GDP ratio. Labour's first budget since the election includes a substantial increase in day-to-day spending, funded by higher taxes, and a rise in public investment spending. This budget is expected to boost GDP and CPI inflation in the near term, making it challenging for the Bank of England to deviate from its gradualist approach to interest rates.
What are the implications of the budget for UK growth and inflation?
The budget composition is likely to be favourable for growth in the near term due to higher government-led demand. Public spending tends to have high growth multipliers compared to tax changes, boosting growth in the near term. However, the rise in national insurance for employers may negatively impact the outlook for UK labour markets over the medium term. Demand and inflation will be higher than previously forecast over the Bank of England's two-year forecast horizon. The budget measures are expected to boost GDP by around 0.75% at their peak and CPI inflation by just under 0.5% at the peak.
What are your current thoughts on UK fixed income markets?
Over the past few years, the Bank of England's aggressive interest rate hikes to contain inflation have driven gilt and sterling-denominated corporate bond yields upwards. Although the Bank has started to ease, longer maturity bonds remain at levels reflecting the expectation of sustained higher UK interest rates. Gilt and corporate bond yields are now back above the yield of UK equity markets, and corporate bond yields are only slightly below the long-term returns of the MSCI World Index.
This is making it quite an exciting time to be a UK fixed income fund manager. Bond yields are offering meaningful income even from government-backed assets for the first time in over a decade. This resurgence in income makes UK fixed income a serious investment choice once again, providing an attractive option for investors.
What is the most significant risk to the outlook?
One of the significant threats facing fixed income investors is the potential for inflation to be stickier than expected. The outlook for inflation remains highly uncertain, although headline rates have moderated from their highs and moved closer to the Banks inflation target. We think that factors such as the shift from globalisation to deglobalisation will keep inflation structurally higher levels in the years ahead.
Arguably though, yields are already high enough to compensate investors for slightly higher than target inflation even over the long-term. For those investors that are significantly worried about inflation then it’s possible to hedge that risk. For example, Insight’s inflation-linked corporate bond strategy combines UK corporate credit with an actively managed inflation hedging component.
How do you add value in the strategies you manage?
That depends on the strategy. Obviously, duration and yield curve positioning are key components in any strategy that focuses on a single market such as the UK. With our gilt strategy those two factors can explain the majority of outperformance over the last five years.
As a major fixed income house, Insight benefits from having a highly experienced team specialising in global government bond markets. We meet regularly to assess the latest data and refine our economic views. We also hold a monthly economics meeting that brings together senior fund managers from our regional offices in an environment where views can be rigorously challenged.
This allows us to develop an overarching view on the trajectory of global rates and identify the areas of yield curves we believe offer the greatest value. We also look for cross market and relative value opportunities. These views are then implemented using a risk budgeting system to ensure that active risk is consistently taken across various strategies and client portfolios. For example, we became quite negative on UK rates back at the start of 2021 and maintained that view for most of the next few years. More recently we’ve taken more tactical long and short duration positions as yield curves have been more range-bound.
In UK corporate bond markets fundamental credit analysis is key. We have a large team of credit analysts whose role is to identify securities whose valuations do not accurately reflect the company's current and future fundamental strength or weakness.
What prompts you to take off benchmark positions?
We do take limited off benchmark positions but generally only when we believe there is meaningful value to extract without compromising portfolio risk. A good example of this is within the gilt strategy where we have periodically allocated to investment grade corporate bonds when spreads are wide, and our investment process suggests they offer compelling value.
We most recently did this at the end of 2022, with an allocation of just over 10%. At that time purchases of short-dated gilts by the Bank of England under the quantitative easing operation had made them expensive relative to investment grade credit. We felt that richness would reverse as the Bank unwound its asset purchase programme, and so we switched from short-dated gilts to short-dated investment grade credit. Obviously, the limited duration of this allocation would have insulated the strategy should spreads have widened.
