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Investors recoil from UK ‘policy vacuum’

High inflation, slowing economic growth and a long summer of political squabbles are making it hard for global investors to love beaten-down UK assets.

UK government bonds and the pound have taken the strain, dropping on worries about just how high inflation could climb. Goldman Sachs has predicted inflation could breach 20 per cent next year if energy prices remain elevated, making the UK ground zero for stagflation — the ugly mix of high inflation and economic stagnation.

Some of the powerful drags on UK markets are global. But for many investors, a lack of clarity over the government’s spending and taxation plans in the face of a worsening cost of living crisis has exacerbated the problem. Prime minister Boris Johnson resigned in early July, but his successor is set to be announced only on Monday. Detail on how the government might help ease the pressure on companies and households will come later.

“The fiscal policy vacuum is causing a lot of uncertainty about the UK, which doesn’t quite exist in the same way elsewhere,” said Oliver Blackbourn, a fund manager on the multi-asset team at Janus Henderson Investors.

“It does feel like the UK is the worst in terms of the stagflation that is sweeping developed markets,” he added. That “is making it very difficult for investors to understand and evaluate UK assets”.

Line chart of Year-to-date % change against US dollar showing Pressure on sterling has intensified in recent weeks

Yields on 10-year gilts have rocketed from 1.8 per cent to 2.9 per cent since the start of last month as prices have dropped, while sterling has dropped more than 5 per cent against the dollar, both marking swifter declines for the UK than for other developed economies.

“Sterling has had a pretty torrid time,” said Francesca Fornasari, head of currency solutions at Insight Investment, who is betting sterling will fall against the dollar. “There’s an unhelpful combination of dynamics, which means that the UK . . . has an additional set of risks that are associated with it.”

She has recently turned even more bearish on the pound, citing “the leadership contest and the discussions around fiscal policy and relationship with [the] EU”.

In government bonds, the value of short bets against interest rate-sensitive two-year debt has risen by 79 per cent this year, according to S&P Global Market Intelligence.

Janus Henderson’s Blackbourn sold gilts in some portfolios ahead of the Bank of England’s last meeting, preferring the bonds of other countries where inflation looks set to peak sooner. “It’s maybe not the best outlook [for] the gilts market, certainly in the short term,” he said.

Some managers are also betting against longer-dated bonds. Crispin Odey, founder of Odey Asset Management, whose European fund is up around 120 per cent this year, has been shorting bonds, including the 30-year gilt, and believes inflation will stay high for “several years at least”.

Mark Dowding, chief investment officer at BlueBay Asset Management, is also shorting gilts and has been betting that longer-term yields will rise relative to shorter-term ones because, he believes, US inflation has peaked and eurozone inflation will have done so by the end of the year, whereas UK inflation will keep climbing.

UK large-cap equities are something of an outlier. The FTSE 100 is one of the best-performing national stocks indices in the developed world this year, down just 1.4 per cent in sterling terms, while the US’s S&P 500 is down 17 per cent and some European indices have fallen by close to a fifth.

But the bulk of companies in the FTSE 100 earn revenues in dollars and other currencies that have gained in comparison to sterling, flattering their bottom line. The index is also packed with energy companies that have performed well during this year’s commodities boom.

In addition, investors appear less willing to enter overtly negative bets against UK stocks than against gilts or sterling. Many are mindful that the UK market’s bias towards cheap so-called “value” stocks in sectors such as mining and energy, which generally fare better than high-growth stocks during periods of high inflation, could mean UK equities continue to outperform other stock markets.

According to data group Breakout Point, there has been a drop-off in shorting activity in UK stocks by hedge funds in recent years. Funds increased their disclosed short bets around 1,800 times last year and 2,200 times so far this year, down from around 6,700 times in 2018.

“I wouldn’t say, on the UK, clients are outright bearish,” said Paul Leech, co-head of global equities at Barclays. “What we’ve seen is an unwinding of risk.” He said that investor sentiment towards the UK and to the rest of Europe is similar, with many investors instead preferring US stocks.

“There’s a lot of bad news out there. But a lot is priced in” to UK stocks, he added. This is providing solace to investors more bullish on the UK’s prospects.

Line chart of Year to date % change showing UK stocks outperform Wall Street

Hedge fund firm Lansdowne Partners’ Peter Davies and Jonathon Regis recently wrote, in an investor letter seen by the Financial Times, that their “belief that there are few sellers of the UK left has probably hardened”.

They added: “we continue to believe that any period of relative calm will quickly see UK assets reprice in a manner that can easily become self-reinforcing”. Lansdowne’s Developed Markets fund has almost half its assets in the UK, compared with one-third in Europe and 15 per cent in the US, according to the letter.

With a large proportion of its constituents in areas such as oil and mining, some managers such as Jupiter Asset Management’s Richard Buxton think the UK stock market looks well suited to current economic and market conditions.

“As a place to lose money slowly — which is all you can do in a bear market — I think the UK is great,” said Buxton, adding that the aim was to have “enough money left to pick up some massive bargains at the end of it”.

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