Views from the LDI desk – May 2024

Decision Time

While on first inspection the inflation print released on 22 May didn’t appear that exciting, with year-on-year inflation measured by CPI dropping to 2.3%, looking below the bonnet there is plenty going on. The print appeared to be close enough to target for Prime Minister Rishi Sunak to pull the trigger a general election on 4 July 2024, perhaps realising the next month or two might be as close inflation gets to target this year.

We briefly look at the details of this latest inflation print and the implications of the upcoming election for the Bank of England (BoE) and Gilts.

Sticky Services Inflation

While the May inflation print showed CPI dropping closer to the 2% target, the 2.3% print exceeded consensus forecasts of a drop to 2.1%. Services inflation again drove the miss. With services inflation printing at 5.9%, down only marginally on April’s 6% and well above the consensus 5.4%, sticky services inflation continues to be a thorn in the BoE’s side on its journey to 2% CPI inflation.

This level of services inflation is not helped by continued strong wage growth, including the 9.8% April increase in the National Living Wage. With that behind us and signs that the economy is wavering in front of the higher prices, with April retail sales surprising with a fall of 3%, the BoE will be hoping that the ability for businesses to pass higher costs onto consumers is becoming more constrained.

While goods inflation has turned negative, services inflation remains stubbornly close to 6%

Alongside falling goods prices, energy prices have been coming down. It is now confirmed that the OFGEM energy cap will fall by a further 7% from July. While this sounds like good news for inflation on the face of it, it’s important to be careful of base effects. This time in 2023, energy prices fell by 12% and were a bigger proportion of the inflation basket as that time. The maths of calculating a year-on-year change in prices means this actually leads to an acceleration in inflation. There are other examples of such base effects dropping out, as the reverses seen in 2023 after the jumps in energy and various other prices in 2022 caused by the war in Ukraine drop out.

This has markets forecasting a small tick up again in inflation as the year progresses, with these base effects coming out while services inflation is only expected to gradually decline.

Market pricing for upcoming inflation prints now show an expected up tick, to RPI back above 4%

Decision time – what does the election mean for the Bank of England and Gilts?

With inflation possibly as close to target as its going to get over this year and headroom for further tax cuts later this year evaporating as rates stay high, Prime Minister Rishi Sunak took the opportunity of the headlines around inflation to call a general election on 4 July. This prompted a statement from the BoE that they would suspend all public engagements and statements until after the election, putting the final nail in the coffin for a June rate cut after the higher than anticipated inflation and bringing greater uncertainty to rate cuts in August or even September.

Higher than expected inflation print and the added complication of an election push out the expectation for BoE to begin cutting rates

Longer dated gilts didn’t particularly react to the announcement, with the election expected in the next six months anyway and whichever party wins facing a fiscally constrained scenario. Polling appears to indicate a labour majority as the most likely outcome. While the manifestos will provide more detail, the key battlelines for the parties along fiscal lines are likely to be on approaches to taxation and investment spending, with the Conservatives likely seeking to continue tax cuts such as to National Insurance while Labour appear more likely to look to promise increased spending to invest for long term growth, which may in time require some revisions to the tax system to fund this.

Whichever party wins, their biggest initial challenge will be coming up with the detailed plans that can convince both the Office for Budgetary Responsibility and the wider market that their strategy will enhance potential growth, boost the labour market and improve productivity. Without growth, further squeezes on budgets will otherwise become inevitable, if the books are to be balanced and fiscal rules met. With plans from the existing government already including real terms spending reductions in key departments in the coming years to meet the existing fiscal rules, some tinkering with the fiscal rules is also to be expected.

Coming years are already projecting elevated levels of gilt supply, prior to any tax or spending policy changes

This is not a trivial challenge for the next government. Factors such as demographics are expected to lead to rapid growth in health and social care bills. The continued need to invest in green technology and climate mitigation creates investment opportunities but requires capital. Defence spending is also likely to remain a priority for whichever party wins power given the current geopolitical backdrop. It is likely that any new government will need to continue to run material deficits for years to come on top of the continued gilt sales being made by the BoE. In a recent speech, Andrew Bailey indicated that these sales would likely continue for some time, with the BoE making use of repo facilities to ensure bank reserves do not fall too low.

These headwinds lead to us maintaining our long-held view that further term premium will build into UK yield curves. We favour positioning hedges to allow for the risk of higher term premia and steeper curves. With the possibility of further yield increases on gilts versus swaps it will also become increasingly important for schemes to think about how they consider and calibrate other investment returns such as credit spreads, but more on this in a future piece.

In summary:

• Inflation is falling, but more slowly than hoped, particularly for services. Base effects are likely to push it higher again later this year.
• The BoE is likely on hold for a while longer given the inflation picture and concerns around perceptions of political bias now the election is announced for 4 July.
• The election timing hasn’t had an immediate impact on longer term gilt yields – was expected in coming months and both parties know they are dealing with constrained fiscal headroom.
• Continue to expect term premium to build into UK yield curves given the tight fiscal position – uncertainty as we head into the vote may accelerate this.

The opinions expressed are as of May 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.

The opinions expressed are as of May 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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