UK assets suffer after BOE’s gloomy prognosis on recession

Struggling UK assets look set for more pain after the Bank of England (BOE) warned of recession in the most downbeat outlook of any major central bank.

The pound slid to its weakest since June 2020, and currency traders are increasingly betting on further losses. Bank strategists expect stocks focused on the domestic economy to continue to underperform, while a measure of corporate debt risk is surging.

The market’s view has turned more negative after the BOE said last week it expects inflation to top 10 per cent this year, driving job losses and stagnation. It is an outlook so bad that traders are turning to short-term UK government bonds as a haven as they bet that policymakers will end up cutting interest rates to prop up the economy.

“The second half of the year is going to be much weaker than the first half,” Steven Major, global head of fixed-income research at HSBC Holdings, said in a Bloomberg TV interview. He said the BOE’s governor Andrew Bailey was “refreshingly candid” about the recession risks, and the window for more rate hikes may not be open for long.

Investors will look to the latest UK gross domestic product (GDP) figures on Thursday for signs of further weakness. Bloomberg economists warn the reading for March is likely to highlight a loss of momentum that could see the economy contract in the second quarter. 

That shows how difficult navigating this juncture will be for policymakers. They will have to balance the weight of their words on markets - particularly the pound as it threatens to fuel even more inflation by weakening - as they prime investors for the road ahead.

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The pound fell below US$1.23 last Friday (May 6) to levels last seen during the pandemic market turmoil of 2020. A test of US$1.21 seems suddenly within reach, said Joe Tuckey, a currency analyst for Argentex. 

Options traders are already piling into bets on a drop in coming months. A gauge of momentum, called fear-greed, implies that sellers have not controlled prices this much since the early days of the pandemic shock.

“Sentiment remains weak and there seems little on the horizon to turn the ship around,” said Tuckey.

UK government bonds initially slid after the BOE hiked interest rates again to 1 per cent last Thursday, though since then short maturity debt has rallied on the prospect of policymakers being constrained on further hikes. 

Money markets still see the bank rate rising to above 2 per cent, though they have trimmed bets on further hikes since the BOE’s meeting. And then by 2024, traders see the BOE having to cut rates to prop up the economy.

“The Bank of England has turned into a reluctant hiker as it is increasingly concerned about the growth outlook,” said Peder Beck-Friis, a portfolio manager at Pacific Investment Management.

That should make UK government bonds resilient to a wider market sell-off, in comparison to euro-area debt, given the European Central Bank is expected to start hiking rates, according to Citigroup. It is targeting the yield premium of 10-year gilts over German bonds to fall to 60 basis points, from around 85 basis points now.

The FTSE 100 index also increasingly appears like a safe haven, especially compared to its mid-cap peer the FTSE 250. The exporter-heavy gauge is helped in part by its inverse relationship to the pound, while a 75 per cent exposure to overseas revenues is shielding it from the UK’s cost-of-living crisis.

Strategists at Goldman Sachs Group, JPMorgan Chase, Morgan Stanley and Barclays are unanimous that they prefer internationally-exposed UK stocks to domestic ones. The country’s weak economic outlook, high inflation, waning government stimulus and BOE rate hikes are among the negatives for local stocks.

The corporate debt market is also sending a message of mounting caution for domestic companies. A measure of risk in the sterling junk bond sector, which comprises mainly local borrowers, rose above 500 basis points this week, the highest since November 2020.

Rising borrowing costs will add to the gamut of challenges weighing on companies, including sagging consumer demand and higher energy prices. An additional concern is the BOE’s plan to start selling off its £20 billion (S$34.2 billion) corporate bond portfolio in September, unwinding support for the credit market in place since the aftermath of the Brexit referendum.

“These credits have held up well thus far with additional stimulus through Covid, but withdrawal of support is likely going to be more damaging,” said Ben Lord, a fund manager at M&G Investments. Bloomberg