New U.K. leader's policies keeping managers on guard

The U.K.'s new prime minister, Liz Truss, has her work cut out for her: Not only is she taking over leadership of the government at a time when citizens and businesses are facing an unprecedented cost-of-living crisis due, in part, to rising energy prices, but she's also still dealing with runaway inflation and the fallout of Brexit.

And while she's working to address these issues, global money managers are worried her policies may hurt bond markets and the country's currency, have only a limited impact on rising inflation and fail to halt a looming recession.

Ms. Truss was appointed on Sept. 6 after a leadership contest following the resignation of former leader of the Conservative Party and Prime Minister Boris Johnson.

The new prime minister unveiled her energy package Sept. 8, with price caps on household energy bills and support for businesses struggling with spiraling costs as Russia's stance on gas and oil plus the war in Ukraine continue to squeeze public and corporate finances. She has already outlined a series of tax cuts.

Sources in the money management industry noted that Ms. Truss' policies also come at a time when inflation in the U.K. continues to climb, the Bank of England has begun raising interest rates, the U.K. is facing a recession, and the effects of the Brexit vote are still playing out.

"With this combination of wanting to cut taxes and also do a big fiscal expansion … ultimately it's going to be inflationary," said Gordon Shannon, London-based partner and portfolio manager in the investment-grade team at TwentyFour Asset Management, part of Vontobel Group. "Big picture, it's how are you going to fund the things you're promising?" Fixed-income specialist TwentyFour has £20.3 billion ($23.4 billion) in assets under management.

U.K. government bonds had already been punished over the weeks leading up to Ms. Truss' emergence as the lead candidate to take over as leader of the Conservatives, sources said, in large part in anticipation of uncertainty under how she would govern.

U.K. gilt yields rose 94 basis points in August, adding a further 35 basis points between Aug. 31 and Sept. 8, when Ms. Truss' energy package was revealed. At close of markets on Sept. 8, the U.K. 10-year gilt yield was 3.15%.

Sources cited her reputation for changing her mind — for example, she had voted in the June 2016 referendum to remain in the European Union, then altered her stance to be a so-called Brexiteer — as one area of uncertainty that may have impacted bond markets.

Sources highlighted that there are other, less extreme changes she's made in terms of her views, as well as some inconsistencies in her economy-related explanations — such as highlighting the need for the Bank of England to fight inflation but also stating the importance of not penalizing homeowners and pensions, which sources said are at odds because hiking interest rates to fight inflation would hurt homeowners. Uncertainty, sources warned, is not something bond markets like.

However, John Roe, head of multiasset funds at Legal & General Investment Management Ltd. in London, said it's better to be "pragmatic" than "dogmatic" — "people are too quick to say changing your mind is a bad thing. I think being dogmatic can be equally bad. But it just means it's very difficult to know where she'd really land on things because it seems to be that, as she gets new information, she sometimes changes that perspective. And that, of course, brings a risk premium with it," Mr. Roe said. LGIM has $1.6 trillion in assets under management.

But there was enough detail in her energy package to garner a negative reaction out of bond markets.

"Gilt and currency markets have not reacted well to the government's energy package," said Silvia Dall'Angelo, London-based senior economist at Federated Hermes Inc. "Gilts have sold off quite significantly since the prospect of large public borrowings emerged, due to concerns about the sustainability of public finances," which has led to higher risk premiums, she said. "While markets tend to overreact, sustainability concerns are not going to disappear," Ms. Dall'Angelo said.

Regarding fiscal intervention and government spending, "the trouble is, the bar has been lowered for these kinds of interventions," TwentyFour's Mr. Shannon said. "I'm not arguing against that, but now you're going to spend over £100 billion on gas — so what is next year's once-in-a-generation (problem that needs spending) — the market is not going to tolerate that."

The fiscal measures outlined by Ms. Truss will temporarily boost growth and put "a lid on inflation," Ms. Dall'Angelo said. Federated Hermes runs $632 billion in assets under management.

But that impact may be short-lived.

If fully enacted, the fiscal measures "will likely have a substantial impact on inflation, reducing it now but limiting its downward trend later," Matteo Cominetta, London-based senior economist at the Barings Investment Institute, said in an email. The institute is money manager Barings' proprietary research unit. Barings has $349 billion in assets under management.

Ms. Truss said the energy cap could reduce peak inflation by 5 percentage points in the coming months. But a fiscal package worth roughly £200 billion — equivalent to 8.6% of U.K. GDP — "fully financed by additional borrowing, will support spending in the next two years. In a context of still-constrained supply, the additional push should be inflationary, or at least limit the medium-term slowdown in inflation," Mr. Cominetta said in an email.

The limited impact of the energy cap on inflation is down to the fact that U.K. inflation is "very broad-based, driven by many factors beyond energy, as shown by core inflation, which nets-out energy and food and it currently runs at 6.2%" — the highest rate in 32 years, he added.

In the medium term, the inflationary environment will need to be combated by "more aggressive policy tightening. Higher inflation and policy rates, together with above-trend budget deficits for years to come all conjure a mix that is rather unpleasant for U.K. gilts," Mr. Cominetta said.

Mr. Cominetta added that the pound sterling is likely to remain under "intense pressure, as the highest rate of inflation in (Group of Seven) countries mixed with slowing growth and persisting Brexit uncertainties all should keep sterling volatility high."

While bond and currency markets will reflect reactions to Ms. Truss' leadership and policies, "it's less obvious what it means in equities, because in reality U.K. equities are global," LGIM's Mr. Roe said. If companies have a dollar exposure on their earnings, a weaker pound sterling means higher shares, he said. Therefore, when it comes to equities "everyone's first thought should be what's happening to the pound and commodity sectors, because we have quite high commodity-sector weights in the U.K.," Mr. Roe said.

Money managers also highlighted that Ms. Truss has come into the role as a recession looms over the U.K. The Bank of England itself warned in its August update — as it delivered a 50-basis-point rate hike to 1.75% — that the U.K. is set to enter a recession starting in the fourth quarter.

TwentyFour's Mr. Shannon said that "what worries me the most is the fact that avoiding recession has become the center point of (Ms. Truss') policy. I think a recession is painful but when you're trying to fight against an economic force, defeat is just inevitable."

Regarding the impact of potentially lower inflation and the energy price cap, Charles Hepworth, London-based investment director in GAM's managed fund solutions team, said: "Consumers and businesses were already struggling with the cost-of-living crisis and energy bills are still capped at three times the price than they were this time last year, so this cap doesn't instantly translate into a consumer-led boom that would have been otherwise. If anything, it could mean the recession is slightly shallower but with a Bank of England still committed to hiking rates, future consumer pain on borrowing is still obvious."

Mr. Shannon agreed that the U.K. will go into a recession, and said that while the consensus is that contractions in the economy are coming, "I think people aren't properly pricing in that a recession will go on for quite a while, and that a recovery will be much slower than the recessions" of recent years, when quantitative easing came to the rescue. "But you've got to think about how policymakers will respond when QE isn't an option — because it's not when inflation is an issue. And inflation might be peaking but it's still high, so huge amounts of monetary stimulus, I think, aren't an option," he said.

For Mr. Shannon, staying out of high-yield bonds, "for me as an investment-grade guy, is an easy choice. But within that (investment-grade exposure), you can go for U.K. but make sure it's non-cyclical." Buying debt of blue-chip U.K. companies, where a lot of the earnings are derived overseas, could be a good spot, he said. "You won't make a quick capital gain on that trade, but you will collect carry for less risk. So the market is paying you a premium because they think you are taking a big risk, but in actuality you're not. So you can try to buy things that are immunized from the bad news — it pays better than trying to predict what the news is," Mr. Shannon added.