Can the UK be at the forefront of the technological revolution required to transition to green? Finance will help but there are no quick fixes and our recent record of harvesting long-term gains from innovation is not great. Let’s hope that our rhetoric is met with action.
Last Tuesday we were poised for a 30-year green gilt issue. However, it was pulled at the last moment as the UK government published its, ‘Net Zero Strategy: Build Back Greener’. The key takeaways are that by 2035 the UK will be powered by clean electricity and that no new gas boilers will be sold from that date; five years earlier we will stop selling petrol or diesel cars. There was investment proposed for carbon capture, higher energy efficiency standards to be required for new buildings and more tree planting. Underpinning the proposed transition is the Green Finance and Innovation initiative, which will look at ways finance can help fund low carbon technologies.
As COP26 approaches the UK government is setting out its stall. Whilst others may follow it is far from certain that commitments will translate to meaningful action. The UK accounts for a very small percentage of carbon emissions (about 1%). Unless we see a dramatic shift from the US, China, India and even Germany, for example, the actions that the UK takes will have no meaningful impact. And this is not to blame the emerging economies: the UK led the industrial revolution and an argument can be made that we have raised our living standards and are now trying to hold back others. What it means for the UK is a dramatic switch to a green economy and higher taxes to pay for the transition. The challenge is to make this transition a boost to the economy rather than act as a drag.
The green 2053 gilt was issued two days late but was a big hit and our allocation was a lot less than we wanted. In yield terms it was sold 1bps through the 2052 gilt and has moved to a bigger differential in open trading. The delay cost taxpayers – as we were able to buy at a higher yield.
Cash and government bonds
UK Consumer Price Index (CPI) inflation came in a bit below expectations at 3.1% (consensus: 3.2%) although Retail Price Index (RPI) pushed on to 4.9% (consensus 4.7%). The largest downward pressure came from restaurants and hotels (the unwind of the Eat Out to Help Out base effect), partially offset by upward pressure from almost everywhere else. Transport, furniture/furnishings and food provided upward surprises. Supply chain effects and staffing shortages may be among factors affecting inflation in the latter two categories.
Purchasing Managers’ Indices (PMIs) were reasonable: the euro area was down but still above long-term averages and the UK was up, buoyed by consumer spending. US PMIs replicated those of the UK: services strong and manufacturing a bit off, but up at the composite level. Japan’s and Australia’s PMIs moved back above 50.0.
Global government yields firmed over the week as short-term interest rate expectations moved higher: 10-year UK gilts at 1.2%, US at 1.66% and Germany at -0.09%. Yield curves generally flattened as short rates pushed up and long yields held in. Looking at the UK, five months ago the spread differential between 5 and 30-year gilts was approaching 1%; today it is nearer 0.5%. This differential has narrowed by nearly 0.4% in the US.
The rise in implied inflation continued in the week, most noticeable at shorter maturities in the UK where 10-year implied inflation (basically RPI) is now well above 4%. More intriguingly, looking at 10-year UK inflation 10years forward – i.e. capturing what is priced in for just the period 2031-2041 – shows CPI inflation at 3.8%; as a reminder the Bank of England (BoE) is targeting CPI inflation of 2%. So, what are investors saying? Implicitly, markets may have lost some confidence in the BoE and are more concerned that inflation will become entrenched. However, I would warn about drawing conclusions from market data. Yield curves and forward inflation rates are a point in time that reflect current circumstances: economic views, market demand and supply dynamics, technical positioning, and present prejudices. It’s good to look at forward rates but treat them cautiously.
Investment grade credit spreads were marginally wider on the week – but there was more noise than genuine direction. There were a few interesting developments in sterling. The RAC issued a highly leveraged bond – offering a 5.25% coupon. This seemed to struggle in the aftermarket despite oversubscription and is now on offer wider than the initial spread. Another issue that was weaker in recent days was ASDA, a sub-investment grade bond issued in the recent refinancing of the supermarket buyout. The failure of the petrol forecourts’ sale saw some widening in spreads.
High yield spreads saw a recovery from recent weakness. Evergrande avoided default through the payment of outstanding coupons and sentiment in emerging market credit generally improved.
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