My last market update was written shortly after the release of Kwasi Kwarteng’s mini budget statement.

To say that the statement was poorly received by the financial markets would be an understatement. Government borrowing costs soared leading to a 20% fall in the value of Government bonds. Thank heavens this was only a mini budget!

Just 2 months later, we have a new PM and Chancellor, setting a different economic course. Thus far, this has been well received by the markets, with bond and share values having recovered from the former shocks.

Pleasing as this chart looks, its worth looking back to gain a better understanding of what happened and assess whether we can expect more of the same in future.

There were 3 forces that fuelled the turmoil;

1 – Truss’s budget plans appeared to be shambolic. The Government provided no plan as to how they were going to fund the sweeping range of tax cuts. This spooked bond markets into raising the cost of borrowing for the Government.

2 – This rise in cost was magnified by global pressures on bond markets, fuelled by slowing economies and rising inflation.

3 – The UK’s final salary pension schemes became significantly more fragile due to the above. Basically, pension funds had borrowed money in recent years to buy more investments to cover future liabilities. In ‘normal’ market conditions, this would be a good plan. However the size and speed of the drop in bond values scuppered the plans. Lenders called in their loans immediately and pension schemes were forced to sell bonds to fund repayments at exactly the wrong time.

Fortunately, the Bank of England stepped in to buy bonds from the pension funds, thus supporting the price of bonds and protecting the pension funds.

So what has happened since Sunack and Hunt took over? Markets breathed a sigh of relief as Hunt’s budget statement reduced the Government’s borrowing requirement. This has lead to reduced borrowing costs and a recovery in Bond values.

Furthermore, inflationary pressures are now thought to be less strong than previously expected, which in turn has reduced the pressures on interest rates. In my last note, we were expecting rates to peak at 6%, before falling next spring/ early summer.

Today, the expectation is that rates will peak at lower levels and fall more quickly. This is good news for both bond and equity markets. The Bank of England’s own projections suggest that interest rates will now peak at around 4.5%.

My feeling is that we will see a rise of 0.5%-0.75% on 15th December, with one further increase on 2nd February. Inflation will probably start to reduce in March/April (as we pass the 1st anniversary of Russia’s invasion of Ukraine), and this will lead towards falling interest rates, probably commencing in May/June 2023.

Of course, there could be unexpected news which delays the interest rate declines, but the longer term trend of falling interest rates is still very likely to happen.

One positive outcome of the UK’s punishment by the financial markets is that it serves as a reminder that Governments must practice responsible financial housekeeping. The new far-right government in Italy campaigned to both reduce taxes and increase energy subsidies. However, Prime Minister Meloni has now back-tracked on this; no doubt aware of what happened over here. Actions such as this help promote global financial stability, which we as investors are pleased to see.

Yesterday, Jay Powell of the US Federal Reserve signalled a slow down in the pace of US interest rate rises. Markets have reacted positively to this news, which supports our own expectations for next year.

UK shares look to be slightly undervalued, whilst bonds have the potential to increase further if interest rates do rise less than previously expected.

As such, I continue to believe that our diversified investment portfolios are well positioned to deliver returns in excess of both inflation and savings deposit rates over the medium to long term.

As always, short term market movements are very difficult to predict. Therefore, Investors who require capital withdrawals from their portfolios in the shorter term should contact their adviser who can help devise a suitable plan of action.

Philip Bailey