Fund Manager’s Response

The debate over whether the UK interest-rate cycle has peaked remains unresolved. While the Bank of England’s Monetary Policy Committee has signalled that the peak may be close, its future actions will be determined by the incoming data on inflation and economic activity.

Although the consumer sector remains vibrant, there is growing evidence of a slowdown in the housing market.

In terms of what is discounted in financial markets, the short sterling futures strip is remarkably flat, suggesting an expectation of steady rates for the foreseeable future. Also, short-dated gilt yields are below the base rate of 4.75%, signalling that the next move in interest rates will be down.

One measure of the degree of accommodation of monetary policy is the spread between nominal GDP growth and base rate. This spread was over 2% at the beginning of the year; however, rates have since been raised. Nominal GDP growth is likely to slow, which would suggest to us that policy is close to neutral at present.

As to price stability, the consumer price index has been decelerating since May and the year-on-year rate now stands at only 1.1%. A fall below 1% on this measure would force the Bank of England governor Mervyn King to write a letter of explanation to the Chancellor. We would argue that the Bank has achieved price stability and that the threat of accelerating inflation at this stage is limited. The rise in the oil price is likely to pose more of a threat to growth than to inflation, and labour cost pressures are well contained.

The current real yield (10-year gilt yield minus the CPI) of 3.6% is right on the 12-month moving average, so we would not argue that the market is at an extreme level of valuation at present. Fixed income instruments are an essential element in any well-diversified
portfolio.

In a low-inflation, low-yield environment, the challenge is to identify and exploit every available source of return. The main return from bonds will come from the coupon income, but there is also scope for modest capital appreciation on the assumption of an unchanged base rate. Corporate bonds also offer a valuable source of yield uplift and Britannic favours holdings in A and BBB-rated bonds.