“A week is a long time in politics”, a phrase ascribed to Harold Wilson, seems to fit the situation in the US pretty well.
Following President Biden’s poor debate performance and the boost given to Donald Trump after the assassination attempt, markets were factoring in a Republican clean sweep. Things look different now. Donald Trump appears rattled, there are growing doubts about his running mate and, most importantly, Kamala Harris has displayed her qualities. The opinion polls show that there is all to play for.
From a bond market perspective there appears to be a clear preference for the economic policies of the Democrats. This is a strange outcome as historically the preference has been the other way. But tax cuts and big spending plans, coupled with tariffs, augur badly for US government debt. Markets can be wrong and strong growth may come to the rescue but it would need to be accompanied by controlled inflation – and markets are not buying this aspect of Trumpism.
The improved prospects for the Democrats may be one reason the US treasury market rallied so strongly, with the 10-year rate ending at 3.8%, down 38bps on the week. Support was also provided by the Federal Reserve, not through the cutting of interest rates, but by the strong hint that policy would be loosened in September. Assuming inflation remains well behaved before the next meeting I think it is likely that we shall see a 25bps reduction. The icing on the cake for bonds was the non-farm payroll data, where there was a substantial downside surprise. The unemployment rate also came in weaker than expected at 4.3%. This set the tone for a further rally in euro area government markets, with 10-year German yields closing at 2.2% and the French equivalent just below 3%. The significant equity sell-off in the latter part of the week, led by the tech sector, only added further fuel to the rally in government bonds.
We did see a 25bps cut in the UK. This was a close call, with the Monetary Policy Committee (MPC) voting 5-4 in favour of a reduction, with three ‘internal’ members changing tact from their ‘Hold’ stance in June. Backing up this change in view, inflation has fallen significantly in recent months and the medium-term inflation projections show inflation below target. Looking at the criteria that the Bank of England has highlighted, there are signs of a loosening in labour markets with unemployment rising and vacancies declining. On other measures, however, the readings and outlook are more mixed. Service inflation remains high at 5.7% and whilst pay growth is moderating, particularly in the private sector, recent public sector awards will cause nervousness at the BoE. The next two inflation prints are likely to be above the current rate of 2% and the Governor, Andrew Bailey, talked about being on “high alert” to inflation persistence. With the economy not falling into recession and services inflation relatively sticky it makes sense for the Bank to tread carefully. However, despite the Bank’s attempt to stifle enthusiasm, the gilt market was in fine form with the 10-year rate nudging 3.8%, last seen in February, and five-year yields closing around 3.6%.
In sterling credit, the problems of the UK water sector remained the dominant issue. Thames Water operating company debt was further downgraded by S&P to BB. Moody’s also placed Southern Water on Review for Downgrade, which could see another issuer lose its investment grade credit rating. In a striking departure from usual commentary, they also indicated that future reviews will also consider whether Ofwat’s actions are consistent with the regulatory framework and cost recovery mechanisms that have supported the current rating level. The implication for investors is clear. A loss of confidence in the regulatory regime will push credit ratings down and capital costs up – to levels way above Ofwat’s expectations – making the current capital expenditure plans unfeasible without even larger increases in consumer bills.
Ending on the theme of water. Both the Thames and the Seine have seen tremendous improvements in water quality in the last 50 years and it was a great sight to see the triathlon swimmers against a Paris background. But the real star in the water has been Leon Marchand. Four gold medals in total, with two achieved in different strokes in a two hour period. Incredible.
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