Monthly Commentary July & August 2017
‘Sell in May and go away’ and ‘silly season’ are both euphemisms for the traditional lull that impacts markets and offices during July and August. However whilst there were no earth shattering events (apart from the literal earth shattering of a North Korean hydrogen bomb test) there were some interesting market moves and some significant data releases. So for those of you who were lucky enough to go on holiday in August here is a quick summary of events written by those of us lucky enough not to have to go on holiday in August.
UK government bond yields fell at all maturities over July and August as investors reigned in expectations of an increase in policy rates and geo-political tensions also rose. 10-year yields fell by 0.2% whilst longer date yields fell by 0.15%.
Yields had risen quite significantly in the last week in June as market participants responded to central bank comments and 3 members of the MPC voting for an increase in the policy rate. However this gradually unwound over the summer. The initial catalyst for these moves was the resumption of missile testing by North Korea which caused an element of flight quality throughout the period as investors sold equities and bought government securities.
The degree to which bond coupons will be more secure than equity dividends in the event of all out thermo-nuclear war remains to be seen. However gold also increased by 7.5% over July and August which also signifies an increase in risk aversion amongst participants.
Economic factors also played a part in the fall in yields. Particularly the inflation and output data that was released over the summer.
Inflation had been gradually rising prior to the summer holiday period with price rises increasing from a 0.9% year-on-year increase in September 2016 to 2.9% year-on-year increase in May 2017 as the fall in Sterling since the EU referendum result started to have an impact. It was expected that this pattern would continue however the increase in process fell to 2.6% year-on-year in both June and July.
Output indicators also indicated a somewhat stagnant economy with Q2 failing to improve on the 0.3% increase in GDP in Q1. Whilst labour markets remained strong with unemployment close to all-time lows this has not fed through into an increase in wages. Whilst forward looking indicators remained relatively strong this had also been the case earlier in the year and so is no guarantee of an increase in GDP in the second half of the year.
The impression given by the data was corroborated by the latest Bank of England inflation report. This suggested that inflation was indeed close to its peak and would slowly move back to target over the coming 2-3 years even if policy rates remained substantially unchanged. Meanwhile growth was expected to dip to 1% in 2017 before picking up to between 1.5% and 2% (still below historical trend) in 2018 and 2019.
“The recent fall in yields over the summer shows that interest risk is not a one way bet and controlling liability risk remains as important as ever.”Robert Scamell, Senior Portfolio Manager
One of the main talking points over the summer was the disconnect between central bank communication and market expectations of future policy. Market participants currently expect The Fed to raise rates slower than The Fed’s own estimates whilst, at the same time, expecting the ECB to be more hawkish around balance sheet reduction than ECB announcements would imply. This is one of the reasons that the euro has appreciated by 13% versus the dollar since the start of the year.
Market participants were expecting further guidance on policy direction during the annual Central Banks conference at Jackson Hole. However both Fed Chairwoman Yellen and ECB President Mario Draghi chose other themes for their main speeches with Yellen choosing to discuss banking regulation and Draghi discussing the importance of free trade leaving market participants none the wiser!
What does this mean for UK pension funds?The falls in yields will have resulted in increasing liability values for pension funds without a significant hedge and given the performance of risk markets over the summer it is unlikely that asset market returns would have cushioned funding ratios for the typical scheme. The recent fall in yields over the summer shows that interest risk is not a one way bet and controlling liability risk remains as important as ever.
30-YEAR NOMINAL GILT YIELD : SOURCE: BLOOMBERG.