Views from the LDI desk – April 2024

The last mile is the hardest

Economic data published during April 2024 in both the US and UK have prompted a re-evaluation of rate cuts and pushed longer dated yields and inflation expectations higher over the course of April.

30yr nominal gilt yields touched 4.75% for the first time this year while real yields held back by increases in inflation expectations.

But while UK yields have moved higher alongside US yields, the two economies are in very different places. The US is showing signs of re-accelerating inflation, a continued strong labour market but also importantly delivering on growth with annualised real GDP growth of 3.4% in Q4 2023 and recent retail sales pointing to 4% year on year growth. The UK continues to suffer from higher than target inflation and high wage growth, but 0.1% GDP growth and flat lining retail sales point to a different growth trajectory.

US inflation is showing signs of re-accelerating

With this piece being written in April, many will be preparing for or have just completed the London Marathon, depending on when you read this. While the author salutes all those who attempt this endurance feat, personal experience of a half marathon several years ago showed that the last mile is the hardest with the finishing line seemingly always still some distance away! The Bank of England (BoE) may be suffering a similar feeling on inflation. The 17 April inflation print of 3.2% beat economist expectations by 0.1% but does continue to move in the right direction at least. April’s inflation print will capture the 12% reduction in the OFGEM energy price cap, which should push the CPI print to close to the Bank of England’s (BoE) 2% CPI inflation target.

But breaking inflation down into goods and services shows that goods are doing much of the heavy lifting, with services inflation stalled at elevated levels, likely to cause concern for the BoE. Despite post pandemic trends towards onshoring supply chains, goods from China, where manufacturing capacity levels remain high, are flooding into global markets and subduing goods prices.

UK services inflation remains elevated at 6%

Wage growth has likely been a key driver of the stickiness of services inflation and April’s Labour Force Survey update from the Office for National Statistics (ONS) delivered mixed news on the labour market. Unemployment unexpectedly increased to 4.2% (although we note the continuing small sample size casts some doubt on this result), but wage growth, also appeared to stall well above 5%, with the 3m average year on year wage growth at 5.6%.

Having been on a rapid downward trajectory wage growth has stalled above 5% p.a.

The impact of this has been to drag expectations of short term yields higher, pushing out the start date for central bank interest rate cuts and with a shallower expected path. While this re-pricing has been led by the US market, expectations for action from the BoE have broadly moved in line with this, supported by the strong wage data and April inflation print beating analyst expectations.

Bank of England interest rate pricing closely aligns with the Federal Reserve

With these two economies in such different stages from a demand and growth perspective, this feels difficult to reconcile. The UK market is pricing around six 0.25% rate cuts in the next 29 Monetary Policy Committee meetings.

At some point we expect to see some divergence in this pricing between the UK and US, particularly if April’s inflation print comes in as expected with UK inflation getting close target. As a result, at the short-end of the curve we prefer to be long UK rates and short US rates, anticipating a divergence in policy path, but the UK inflation outlook is not without risks in the months ahead and an acceleration as the year progresses, as seen in the US, is a feasible outcome.

Risks of an inflation rollercoaster in the UK?

Several areas heighten concern that the last mile in the battle to get inflation to 2% could drag on for the UK, despite relatively weak UK growth and demand.

Energy prices and Geopolitics

Tensions in the middle east along with increasingly widespread Ukrainian drone attacks on Russian oil and gas infrastructure have caused Brent crude and natural gas prices to increase. While these remain below levels reached in September 2023 and prior years, should these tensions remain or even further escalate this will create short term inflation pressures and market pricing has already reacted to this to some extent.

Oil prices have moved higher on the back of geopolitical concerns in the Middle East

Sterling and imported inflation

If UK rates do diverge from US rates or even if this is priced into markets, Sterling is likely to continue to weaken against the US Dollar. While much of the UK’s trade is with other regions such as Europe, who also look to be on a path to earlier cuts, commodities priced in US Dollars would increase in price. The UK and Europe cannot completely decouple from the US direction of travel on rates and inflation.

Short-dated inflation expectations are sensitive to Sterling

Food prices

While the pace of food price inflation has been slowing (and even turned negative in January) there are reasons to be cautious about the future path. A large component of food price inflation was driven by energy and other input prices such as fertiliser costs post the war in Ukraine, issues closer to home may start to exert upward pressure. After an exceptionally wet winter, harvests are expected to be poor, with a recent survey indicating a 79% increase in land left fallow, with conditions often too poor to plant crops. Meanwhile, May see’s that the start of new food biosecurity checks for some goods entering the UK from the EU, with costs to be borne by food importers.

Demographics and labour market structure

The excellent recent piece by BlackRock Investment Institute highlights demographic trends facing many economies globally and the potential inflationary impacts of this. While the UK is by no means the worst effected, post pandemic labour market structure continues to be a challenge. We note the recent uptick in the inactivity rate to 22.2%, which is now particularly growing among what would usually be considered working age 16 to 34 people rather than early retirees, with long term illness and remaining in education being the main drivers. These factors risk creating continued pressure on wages.

Government spending and election politics

With a UK general election generally expected in the autumn and polls showing the Conservative party significantly trailing Labour we expect further tax cuts to be announced in the autumn, although the recent increases in interest rates may challenge the fiscal headroom for this. Tax cuts stimulate demand and may add to what has been primarily supply driven inflation, but as the IMF recently flagged they also worsen the UK’s fiscal position and this may put further pressure on long term rates.

What does this mean for UK pension schemes?

• While we expect the next BoE change in rates to be a cut, the US outlook and continuing strong wage growth in the UK presents material risks to the timing of cuts.
• If US rate cuts don’t materialise in 2024 this may limit the extent of action other central banks can take given potential currency effects and the risk of imported inflation from commodities.
• This could flow through to longer dated rates, as already stretched fiscal positions become more challenged.
• We continue to advocate for schemes managing interest rate and inflation risk closely, but considering the rewards of a modest under hedge if longer dated rates were to move higher and require asset allocation changes to top up LDI collateral.

The opinions expressed are as of April 2024 and are subject to change at any time due to changes in market or economic conditions. The above descriptions are meant to be illustrative. There is no guarantee that any forecasts made will come to pass.

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