An explanation to last week’s financial market events……………
Given the events of last week we felt it appropriate to communicate to our clients a summary of last week’s events in financial markets. You will no doubt be well aware of the recent ‘mini budget’ announced on Friday 23 September and the subsequent fallout and impact this has had to our financial sector. You will also have heard about increased market volatility over recent months in the wake of political instability in Eastern Europe following Russia's invasion of Ukraine. In addition to this the growing cost of living crisis which is putting people’s finances under greater pressure.
All of this may impact your ability to save as well as the valuation upon your existing savings/pension fund/other investments and it can understandably be worrying to see short term fluctuations in value. However, it is important not to panic and consider the current volatility in relation to your long-term investment goalsand objectives.
For anyone who is investing over the longer-term, short-term ups and downs should be expected. The current situation in respect of the fallout from the mini budget combined with ongoing events in Eastern Europe may lead to a period of ongoing market volatility but making short term investment decisions may have an impact on longer term investment goals
All things considered though, we are of the opinion that there are reasons to be optimistic about investing, specifically in the UK markets at thistime, despite the turmoil of the past week. The beginning of last week saw a great degree of volatility resulting in the Bank of England intervening which calmed the markets.
This uncertainty led to various banks withdrawing mortgage products as they anticipated higher interest rates as partof the Bank’s attempts to bring inflation back under control.
We understand that you may well have been alarmed by the mediacoverage of these events, who, once again, inour opinion, manage to whip the public up in to a state of frenzy and fail to explain the whole picture. This article is designed to provide you with a professional insight and our thoughts and views on this.
What it all means…
Last weeks events affect allof us living inthe UK in some way or another, whether an investor, saver, mortgage borrower, allornone of these! Declines in the value of the pound mean that the goods we buy from abroad (most notably oil) will become more expensive to import. At a time when inflation is of great concern to most households, a plunge in the pound only makes matters worse.
Borrowers are affected as sharp falls in the pound have led to concerns of further interest rate rises, which if they come to fruition wouldlead to higher costs for mortgage holders.
The Bank of England recognises that the economy is operating at near full capacity and if it accelerates from here, it will generate more inflation rather than improve living standards. (Source – Brewin Dolphin Investment Managers – September 2022)
What wehave is the government focusing on and striving for economic growth when the Bank of England is trying to slow the economy down to ease inflation –predominantly through interest rate increases. A good analogy of this is the government putting its foot on the accelerator whilst the Bank of England is pushing on the brake!
Because the economyis operating at near full capacity, the government is unlikely to achieve its 2.5% growth target particularly soon – and that means less tax revenue at a time when the government is already borrowing too much. This is exacerbated by the fact that the tax cuts were targeted at the highest income cohort, which is the group that is least likely to spend them. This reflects the government’s belief that this group willinvest their savings in ways that cause economic benefits to trickle down to other economicparticipants. That is a controversial theory, one open to political opinion and not for us to comment on here.
Another reason why markets reacted so poorly is that the government’s borrowing costs are likely to increase. Bond prices tend to fallwhen interest rates rise. When bond prices fall it means their yields rise, and these form the minimum long-term interest rates for borrowers in the UK. This raises the cost of borrowing over long periods of time. The government will be borrowing more money next week at what could be a higher interest rate. Over the coming years, the volume of new borrowing and the higher rate of interest on those loans could push yields up further still.
This extra borrowing – in a way which may not generate much growth, would need to be offset by higher interest rates and is in pursuit of economic benefits which many are sceptical of – is why the markets were so rattled.
Originally, the government doubled down on its position that tax cuts were the best policy for the UK, with chancellor Kwasi Kwarteng saying more would be coming when he presents a fullbudget in November. However, the market was further unsettled by these remarks and there is a possibility that his plans for the budget may need to be reconsidered. In fact, at the time of drafting this bulletin ithas just been announced that the government are proposing the abolishment to the cut to the 45p top rate of income tax.
In the meantime, there was a suggestion that the Bank of England should enact an emergency interest rate hike to support the pound. However, this was rejected by the Bank, which emphasised that it uses monetary policy to control the level of demand within the economy (as described earlier) and would do so at its nextscheduled monetary policy meeting in November. This seems appropriate and a balanced response. It had been expected to raise interest rates at future meetings and now the trajectoryof those interest rate increasescould be higher. The Bank has intervened to curb the extent of the rise in UK bond yields. This is because they were threatening to create a vicious cycle of selling. It said it will start buying government bonds at an “urgent pace” to help restore orderly market conditions. This is a temporary measure. The newly purchased bonds will be sold back into the market, and the Bankstillplans to start selling back the stock of bonds it accumulated during recent quantitative easing programmes. Take up of the first tranche of the programme was reassuringly small, suggesting that the intervention has restored confidence without interfering with the Bank of England’s longer-term plan to tighten monetary policy.
The extent of the volatility following the mini-budget has caused some real anxiety for the UK financial system. However, the Bank of England does seem to be able to control the situation. One of the advantages of the UK having its own currency is that it makes the prospectof being unable to meet its liabilities entirely negligible.
So why is my investment plan value going up and down?
Your investment arrangements will be invested in a mix of different types of investment (for example equities (company shares), bonds, physical property and cash). Thismeans the value of your plan can go up and down depending on how each different investment type is performingat any given time.
When investment markets are experiencing volatility, the value of your plan may also go up and down. Were your plan to be invested in only one investment type it will be entirely exposed to the ups and downs of that particular type of investment.
What causes investment markets to be volatile?
Investment markets can be affected by a number of external factorssuch as:
Political and economic uncertainty
conflicts
concerns
Fiscal policy changes from Governments (tax changes)
Any one of these events can cause markets to move up and down more than would be typically expected over the short-term.
How can my plan value drop if I’m in a lower-risk strategy?
Even investment types that are typically considered low risk can experience ups and downs in value if investment markets are experiencing short-term volatility. Typically, equities (stocks and shares) are the most volatile asset class to invest in with the greatest degree of peaks (when markets rise) and troughs (when markets fall). Bonds (loans to companies and Governments) and Gilts are referred to as fixed interest assets and are typically less volatile. However, what has been happening recently is a ‘disfunction’ in the UK market following the fallout from the recent mini budget. This caused bond valuations to fallwhich willstillbe felt by more cautious investors who will typically hold a greater degree of this asset class within theirportfolio. You will be pleased to know that the Bank of England intervened on Wednesday last week to take measures to stabilise the market. These measures were designed to both strengthen the pound and return stability to the bond markets.
What’s happening with interest rates and the fact that mortgage products have been withdrawn?
The combined effect of a weakened pound, very high level of inflation and the market reactions to the recent mini budget, we expect that interest rates will have to increase. Note that as of today the Bank of England base rate remains historically low at 2.25%. The Bank of England chose not to increase interest rates via an emergency Money Policy Committee meeting this week.
What we saw last week were various mortgage lenders withdraw some or all of their mortgage product range without any prior notification. For example, on Wednesday of last week Clydesdale Bank, Virgin Money, Skipton Building Society and Halifax all withdrew or reduced their product range. This made spectacular news coverage and judging by the amount of phone calls and emails we received caused great concern for mortgage borrowers which is understandable.
What wehave not seen reported is the fact that most of these lenders have now reintroduced their products albeit at what are increased interest rates compared to a week ago.
This is despite the fact that the BoE has kept base rate at 2.25%. What isdriving the increase in mortgage pricing is the fact that ‘swap rates’ (which are the interest rates that banks use when lending between each other). Swap rates are priced in accordance with where interest rates are expected to be going in the future, (not necessarily aligned to the current Bank of England base rate) and have been increasing over recent days.
So, unlike the days of the ‘credit crunch’ back in 2010, wedo not have a liquidity or funding crisis in the mortgage market but a different scenario that lenders face – are interest rates on the increase and by how much?
This has created a scenario of most of the high street lenders experiencing huge inflows of what they call ‘speculative applications’ wherepotential borrowers are applying for mortgages, perhaps to multiple lenders to secure a mortgage offer prior to potential future increases. In order to avoid this, some lenders took the view to temporarily suspend applications for new business, withdraw their product range, stand back for a few days, watch developments, reconsidertheir pricing and then reintroduce their mortgage products.
What is also relevant to the withdrawal of so many products over recent days, is that when a lender is offering what are very attractive interest rates they willnaturally be attracting the highest proportion of the market share of new business applications.
Mortgage lenders areonly able to process a set amount of applications at any one time and in order to reduce or restrict their inflows they willincrease theirinterest rate offerings to make themselves less attractive and this slow downtheir volumes. Many mortgage lenders (the high street banks included) cannot cope with the volume of business coming theirway amid increasing interest rates. This is partly due to their ongoing difficulties of continuing to navigate hybridworking but also to what has been a constantly changing base rate over recent months. We experience slow turnaround times from most lenders just now. What is happening is that when lenders reach the top of the ‘best buy lists’ they panic as they will be swamped with new business so they pulltheir rates – usually with little and now without any notice – in order to reduce their competitiveness to say 6th or 7th place. Nearly alllenders have intense backlogs of applications.
We explain this as these are all dynamics that the media do not explain as they do not make exciting headlines! Their message will simply be along the lines of ‘mortgage products reduced by 1,000s! They fail to explain the full rationale behind this and create shockwaves.
Now that we are a week or so in to these developments the picture is becoming clearer in that although the number of mortgage products available remains lower than it was a few weeks back it is an improving situation. What is becoming clearer is the higherthe cost of borrowing now that all these mortgage ranges have now been re-released.
It is important to understand that if you are looking to either refinance or borrow new funds going forward, you need to be prepared that the days of hyper low interest rates are nowbehind us and the cost of borrowing is reaching more ‘normal’ levels. We have all enjoyed 10+ years of extremely low interest rates and even if they reach the 6% ish level, the graph below shows how this compares to where the BoE base rate has been since 1975:
So what should I do?
As an investor…
We will outline here our thoughts to both mortgage borrowers and investors.
In respect of investors, our recommendation at this time is to keep calm, understand the reasons behind the recent volatility and keep a cool head. Investment markets have always been and will always be volatile. The UK economy remains fundamentally stable with the backing of the solid institution of the Bank of England. The Bank of England showed its financial might by acting extremely quickly and forcefully last week and bringing swift stability back to the bond markets. This had the desired effect and stabilised the Pound. It is fair to state that all investors will have to continue to expect ongoing volatility. As stated above, there are multiple dynamics at play here which stem from the war in Ukraine which has fuelled global increases to energy and oil prices resulting inincreases to inflation. This could take a long time to play out and will unlikely be resolved in the short term.
History has shown us that the general, longer-term direction of travel for investing (whether this be in equities, bonds, gilts, property or any combination) has been upwards. Our opinion is that this will continue. Markets will recover,they always have – its simply a question of giving it time.
The chart below shows the actual returns on various asset classes including inflation, cash, global bonds, UK gilts, UK equities, emerging market equities, European equities, Global Equities and US Equities. This is designed to show you the impact of how historic events have impacted investment markets and their subsequent recovery.
These events include Covid 19 outbreak, Brexit, European sovereign debt crisis, UK starting quantitative easing, Lehman Brothers bankruptcy and credit crunch etc. The specific detail on thisgraph willbe too small to see when included here so we will include this as a separate page at the end of this bulletin.
Source – Vanguard.co.uk – Oct 2022
We have said this time and time againand our message and advice remain the same at this time – long term growth comes from ‘time in the market’ and not trying ‘to time the market’. In other words, stay invested, ride this out and do not look to sell to cash and buy back in the belief that markets are about to turn in your favour.
Key factors behind this rationale include the facts that:
1. Time in the market, not timing the market, delivers returns.
2. Compounded long-term returns tend to outweigh the losses prompted by episodic crises.
3. In the context of high inflation, cash is riskier than equities for capital preservation.
Trying to time the market to buy before 'good' days and sell before 'bad' ones is impossible. Staying invested is critical to capture allthe good days that drive returns, but inevitablythat means accepting some bad ones too. While it can be uncomfortable, it is better to stay invested.
And while it is never comforting to see negative returns as investors have done recently, it is important to put things in perspective. If we look at stock market returns since December 2007 – thereby capturing the financial crisis, the Eurozone crisis, Quantitative Easing, Brexit, Covid and war – both cumulative and annualised returns remain strong.
Higher risk assets such as equities may appear volatile and will fluctuate. However, in an inflationary regime, they aresafer than cash over the medium to long term.
Over five years, an allocation to equities delivered a price return of -1.3 per cent (-0.3 per cent annualised) while cash lost -54 per cent of its purchasing power (14.2 per cent average annualised inflation).**
Over 10 years, an allocation to equities gave a price return of +72.9 per cent (+5.6 per cent annualised) while cash lost -73 per cent of its purchasing power (12.4 per cent average annualised inflation). **
And over 20 years, an allocation to equities delivered a price return of +473.7 per cent (+9.1 per cent annualised) while cash lost -84 per cent of its purchasing power (8.8 per cent average annualised inflation). **
** Source – FT Adviser – September 2022
What you can read into this is that basically ‘time dilutes risk’.
As humans we are naturally loss averse – a lost £1 gives more pain than a gained £1 gives pleasure – but in an inflationaryenvironment it is important that investors are not paralysed by risk aversion.
So in summary our advice is to remain invested and ride this out – as we have always said historically and has shown to be the correct course of action. You may wish to reassess the level of your investment risk tolerance and we willbe pleased to help you with this. The easiest method for this is for you to log into your personal Wealth Platform portal and follow the process for undertaking a new risk assessment questionnaire – this is very straightforward. Alternatively, contact us and we can assist you with this.
We remain committedto managing your wealth and advising on howbest to achieve financial prosperity. This is a time for cool heads once again and not a time for any knee jerk reactions. Markets will remain volatile for the foreseeable future. It is a time to stand back from all the media hype, understand what is going on but do not feel pressured in to any sudden change of direction. We have always recommended well diversified and professional managed investment strategies that are designed for the medium to long term investment horizon. There will be bumps along the journey and recent weeks have shown this to be the case, however, as in previous ‘market events’ by remaining invested these lower valuations have recovered and gone on to real growth.
As a mortgage borrower…
We have all our clients’ mortgages scheduled for review prior to the end of their current rate period expiry. These are generally diarised for review 3to 4 months prior to reversion to their standard variable rate. What has come about recently is that several lenders have now extended the period at which time you can secure a new ‘product transfer’(rate switch) to as much as 6 months prior to the expiry of the current rate.
Given that it is fair to suggest that the likely general direction of travel for interest rates is to increase, you are best advised to secure a new rate as soon as you are able to. As well as product transferdeals being available 6 months in advance, we are now also seeing lenders offer remortgage schemes which have an offer validity period of 6 months from the date of the offer being issued. This means we are able to apply now and secure a remortgage offer on an interest rate that would hold good for into what would likely be in to April 2023 given that any applications submitted now would not likely go to offer untilearly November.
As always, if you would like to discuss or review your personal scenario please just contact your adviser.
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UK general election: Conservatives lose
WHO declare Covid-19 outbreak a pandemic
US general election: Joe Biden (democrat) wins
US equities £287,669 11.85% (annualised)
Global equities £164,102 9.78% (annualised)
European equities £134,970 9.06% (annualised)
Emerging market equities £124,411 8.77% (annualised) UK gilts £69,835 6.69% (annualised)
UK equities £100,777 8.01% (annualised)
Global bonds £56,998 5.97% (annualised)
Cash £28,270 3.52% (annualised)
Inflation £23,412 2.85% (annualised)