What’s behind the market volatility in the UK?

On the latest edition of Market Week in Review, Investment Strategy Analyst BeiChen Lin and Research Analyst Laura Bardewyck unpacked the key factors that led the UK government to announce a massive fiscal package last month, as well as the volatile reaction to the plan in UK markets. They also discussed other key market watchpoints, including investor sentiment and the latest U.S. inflation data.

Why did the UK unveil a massive spending package?

In order to understand what drove government leaders in the UK to unveil a massive - and controversial - spending plan last month, Bardewyck and Lin opened the conversation with a look at the key economic challenges confronting the nation. Lin said that the UK is facing a double-whammy of very high inflation - hovering near double-digits - and a deepening energy crisis, each of which could tip the nation into a recession this winter.

“Both of these issues have led to very tough times for British consumers, with food and other everyday items becoming increasingly difficult for some individuals to afford,” he explained. It was against this backdrop, Lin said, that Finance Minister Kwasi Kwarteng announced a massive spending package on 23 September - complete with caps on energy prices and tax cuts - to try to stimulate economic growth.

How are markets reacting to the plan? And to actions taken by the BoE?

Lin said that the announcement of the plan triggered massive upheaval in UK markets, with the value of the British pound plummeting against the U.S. dollar amid a large selloff in long-dated UK government bonds, known as gilts. At one point in late September, the yield on the 10-year UK gilt spiked to 4.6% as investors dumped government bonds in droves, he noted.

“Essentially, the announcement of the fiscal plan, or mini-budget, led many to wonder how exactly it would be paid for. In response, investors began betting that the Bank of England (BoE) would be forced to raise rates even more aggressively to compensate for all the government spending in order to still bring inflation under control,” Lin explained.

The rout in bonds and plunge in the pound ultimately led the BoE to take the extraordinary step of immediately purchasing gilts in order to ensure stability in the value of both the pound and UK government bonds, he said. Lin added that earlier this month, government leaders backtracked on some elements of the spending package, including scrapping plans for tax cuts for some of the wealthiest British citizens. However, UK markets have remained in turmoil, he said, especially due to recent statements by the BoE that it will have to stop buying bonds soon. "The UK central bank will eventually need to halt its bond purchases in order to control inflation, although some investors are now speculating whether the BoE could potentially buy bonds for a longer period of time than expected," Lin remarked.

Overall, the situation remains complex and fast-moving, he said, with the yield on the 10-year gilt edging down to around 4.2% as of market close on 13 October Investors should be prepared for additional volatility in UK markets, Lin stated, emphasising that amid all the turbulence, it’s important to stay disciplined. "Ultimately, in these uncertain times, I believe it's crucial for investors to stick to the plan they have in order to best weather these economic and market challenges," he remarked.

The importance of paying attention to investor sentiment

Shifting his focus more globally, Lin said that beyond the turmoil in the UK, investors are also focused on the upcoming U.S. Federal Reserve (Fed) meeting in November. Markets are pricing in another jumbo-sized rate hike of 75 basis points, he noted, amid expectations for the central bank to continue its aggressive rate-hiking campaign.

Another key watchpoint for investors is the inflation situation in the U.S., Lin said, noting that the recently released September CPI (consumer price index) report showed inflation running a little bit hotter than expected. Interestingly enough, however, the benchmark S&P 500® Index ultimately closed higher on the day of the report’s release, he added.

Lin also stressed that for investors, he believes it’s critical to pay attention to more than just the latest economic data releases - especially during today’s turbulent markets. "At Russell Investments, we’re also paying close attention to investor sentiment, which has become very oversold. This is important, because when sentiment is this oversold, it can sometimes create situations that lead to a market bounce - even though the data itself might not be that great," he concluded.

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Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.