Will markets forgive the UK?

Good morning. Gilts and US stocks both ended yesterday near where they began, which we take to mean the drama has ended and we can all go home now. Wishful thinking? Email us: and

The UK governance risk premium 

When last we checked in on the gilt market drama, Tuesday afternoon eastern time, Bank of England governor Andrew Bailey had just given UK pension funds a bracing talking-to. The bank’s intervention in the gilt market would not last for ever. If you have to liquidate UK bonds, lads, do it by Friday or you’re on your own; “You’ve got to get this done.” At this point, Unhedged wrote a newsletter about the risks of waving an ultimatum in the face of the bond market, had a drink, and went to bed. Up Wednesday morning, your correspondent was greeted by this report from his FT colleagues:

Representatives from the central bank informed some lenders on Tuesday that it was prepared to extend the facility past the October 14 end date if market conditions demanded it, according to three people briefed on the discussions.

“They told us that they were watching the LDI managers closely to see whether they had managed to generate enough liquidity for their clients to cope with margin calls and would decide whether to extend the facility on Thursday or Friday,” said one banker.

I can think of three more or less plausible reasons for this contradictory messaging. They are:

  1. Badly bungled internal and external communications at the BoE. The BoE officials who told the senior bankers that Friday was not a hard deadline had not been informed about what Bailey was about to say, or some similar screw-up.

  2. The BoE is split into factions — perhaps between officials who think financial stability is the top priority and those who think price stability is the top priority — and the two factions are making different plans and sending different messages.

  3. The senior bankers who spoke to the FT reporters simply lied about, or at any rate seriously exaggerated, what they had heard from the BoE officials.

Readers can pick their favourite, or suggest others. I’d guess it’s a convoluted combination of the three, not based on any inside knowledge, but rather on the general principle that life can be counted on to provide a messy answer when what we want is a clean one.

In any case, there were suddenly doubts about the BoE’s firmness of purpose, with predictable results in the gilt market yesterday morning: more pain. Tuesday night, 30-year gilts yields had closed at 4.8 per cent. They hit 5.1 per cent at 2pm Wednesday. But then came the news that the BoE had — in contrast to previous sessions — bought almost all the bonds that were offered to it on the day. Things reversed.

It is not clear whether the BoE was able to buy so many more bonds because pension funds had been motivated by Bailey’s Tuesday ultimatum or because the BoE had decided to be less picky about price. We will learn more over the next two days. Bailey has not won his gambit yet.

The unsteady way the bank rolled out its market intervention; the apparently unnecessary and possibly unenforceable ultimatum; the mixed messages — all of this is fodder for the view that the recent increase in UK bond yields, especially at the long end of the curve, in part reflects a risk premium that compensates for the fact that the UK is now so poorly governed. The Economist, for example, sees “little doubt” that this is happening, citing downgrades to rating agency outlooks.

Others are not so sure. Michael Howell of CrossBorder Capital, for example, points out that if such a premium were being applied, it would appear as a term premium. That is, long bond yields would have a yield higher than the sum of expected short-bond premiums. But no such premium has appeared. Howell shared the below chart on Twitter last week, suggesting what was causing the move in gilts was a spike in policy rate expectations:

Another place one might look for a UK risk premium is in the expected volatility of the currency. Below is a picture of options market implied volatility of the pound/euro exchange rate (using the dollar exchange rate when the Fed is increasing rates against the rest of the world sends a less clear signal). Expected pound volatility is up, but not wildly:

Others (including former BoE deputy governor Paul Tucker, in a recent talk) have noted that expected inflation — measured as the gap between nominal and index-linked bonds — has not risen.

I think that Howell and Tucker have a point. Certainly, we can’t judge whether the UK is or will be paying a lasting premium for poor governance until UK bond and currency markets are back to something like normal functioning. The UK does not have a monopoly on bad governance, even at this chaotic moment. The bond market may prove surprisingly forgiving.

Welcome to earnings season

It was only a matter of time until tighter monetary policy came for corporate earnings. Smart people thought S&P 500 earnings per share would fall in the second quarter but, thanks to bumper profits in the energy sector, earnings grew 5 per cent.

Don’t expect a repeat. Third-quarter EPS will probably fall below the second quarter’s. From slowing demand to a strong dollar, the list of drags on earnings is formidable. Profit warnings, notably from economic bellwether FedEx, are piling up. Analysts’ EPS estimates for the third quarter, a lagging indicator that has looked too optimistic all year, have already plunged 7 per cent in the past three months.

And yet expectations for 2023 have barely budged. Compare estimates for this year’s third quarter to the second quarter of 2023 (which broadly mirrors the overall 2023 outlook):

Analysts have gotten behind bad earnings for now, but not really for next year (do you think earnings are going to grow 9 per cent between now and next June?). 

The problem here is that stocks have, for the past 11 months, fallen in dribs and drabs, a few percentage points at a time. We’ve had no big capitulation event, no catharsis. There doesn’t have to be one. The bear market of 1982 never reached a culmination point. But to reach some kind of bottom we do need two things: stable earnings expectations and stable valuation multiples.

To get stable earnings expectations, they first need to come down. Recession, mild or severe, seems likely next year, and on average recession means EPS down 17 per cent. This is where earnings season could help. If companies talk down guidance for next year, that could give earnings expectations, and therefore prices, an overdue kick, laying the foundation for a market bottom.

And to get stable multiples, we need a clear inflation and rates trajectory. As John Porter, chief investment officer for equities at Newton Investment Management, put it to us:

When you talk about interest rates and earnings expectations, you’re really talking about what’s the right multiple. The right multiple is driven by the level of inflation and interest rates, more than anything else.

So getting some confidence around where interest rates are going to settle out will go a long way towards figuring out: “Do we want to put a 14x multiple on this thing or a 17x multiple or a 20x multiple on the earnings?”

Another wave of bad inflation news, driving up the expected terminal policy rate, could knock P/E ratios down another notch. Still, note how far multiples have come down already:

There is, at least, more progress towards reality here than in the 2023 earnings estimates.

One good read

We are torn on legalising cocaine, but this is a good case for it.

Read the full article here

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