By GRAHAM FROST 06/07/2007
The UK economy is in the midst of a gripping power struggle between growth, inflation and interest rates. The eventual outcome could have a significant impact on us all, so it’s important to keep an eye on what’s going on.
| "The prices of UK gilts have taken another step down..." |
After a short rebound in February the prices of UK gilts and quality corporate bonds, which tend to be closely correlated, have taken another step down; UK corporate bond funds experiencing, on average, a 4% fall in capital values in the period from the beginning of March to early July. The chart shows the extent to which gilt yields have risen (hence gilt prices have fallen) over the last year.
These falls are partially the result of further tightening by the Bank of England, which this week raised base interest rates (for the third time this year) to 5.75%. Some groups, like Capital Economics, expect rates to rise to 6% and even beyond. Rather different from expectations earlier in the year.
What has caused this change in outlook? Generally speaking price rises in goods and services have become more widespread, as companies have taken advantage of improvements in their pricing power to pass on costs and/or raise margins. With a few exceptions, bond prices have an inverse relationship with interest rates, and consequently as interest rates rose bond prices fell. Such movement has been a global phenomenon, as world growth expectations have improved. So far the increase in bond yields has by and large been shrugged off by equity markets, which continued to hit new highs. There is a possibility that we may see a re-pricing of risk in the shorter term, as market participants come to terms with higher gilt yields and their impact on relative equity valuations. For the time being we still believe equities, and in particular large companies, are still attractively priced against fixed income assets. On the other hand, medium sized companies, which have led the equity markets over the last 4 years, are priced at higher valuations and could be more susceptible to relative underperformance, as we’ve seen over the last quarter.
| "Going forward the risk is that the Bank of England’s attempts to head off inflation could result in a greater than anticipated cooling in GDP growth." |
Going forward the risk is that the Bank of England’s attempts to head off inflation could result in a greater than anticipated cooling in GDP growth. Rising interest rates tend to have a lagged effect, as their impact gradually filters through the economy. This could spell bad news for the housing market further down the line, which in turn could have a knock effect on the consumer and broader levels of economic activity.
Commercial property may also suffer, when compared to the higher, risk free, rates available from gilts. Meanwhile the market, which tends to look ahead, is still pricing in the expectation of at least one more quarter point rise, leaving some room for a bond rally further out should the economy lose momentum and further rises prove unnecessary.