INSIGHTS

Politics hasn’t been the key driver of financial markets in 2022. That mantle still goes to rampant inflation and rising interest rates.

However, we shouldn’t underestimate how much all the UK drama has added to the uncertainty.

UK financial markets have had a wild ride over the past two months.

In addition to the death of the Queen in early September, we saw Liz Truss appointed Prime Minster, a major energy relief package and a "mini-Budget" with a raft of ambitious tax cut proposals.

The market reaction through this period was intense. The British pound tanked almost ten per cent in the space of a week, slumping to a record low against the US dollar.

Meanwhile, the yield on five-year UK government bonds rocketed up by 50 basis points in a day, the biggest one-day increase since 1985.

Those votes of no confidence from financial markets added to the concerns about the UK economy, at a time when it is grappling with double-digit inflation and a seemingly inevitable recession.

With a budget deficit of almost eight per cent and a current account deficit of more than five per cent, higher borrowing costs and a falling currency do no favours to the UK.

Then there are the defined benefit pension funds, which have increasingly used leveraged Liability Driven Investment (LDI) strategies to meet their obligations.

Explaining what that means in a few sentences is difficult but in short, they've used derivatives to hedge their interest rate and duration risk, to offset the difficulty of generating reasonable returns after three decades of falling interest rates.

In the last ten years, total assets in these LDI strategies have quadrupled, and the aforementioned volatility has exposed this riskier behaviour.

The sudden spike in bond yields threatened to exceed the capital cushion for many funds, which would’ve put them in an uncomfortable position.

They would've been forced to either sell bonds into a falling market, or ask their trustees to provide more capital.

This situation led to unplanned interventions from the Bank of England, followed by the abrupt appointment of a new Chancellor and a near-complete abandonment of the mini-Budget.

It all culminated in Liz Truss's resignation some ten days ago, making her the UK's shortest serving Prime Minister.

Despite all this, the UK sharemarket has held up better than US or New Zealand since the end of August, and it’s been one of the world’s top performing sharemarkets in 2022 overall.

The FTSE 100 in the UK is down just 1.9 per cent (including dividends) this year, well ahead of the S&P 500 in the US (down 19.3 per cent) or the local NZX 50 (which is 16.4 per cent lower).

Many listed UK companies are multinationals, which means are less exposed to the domestic UK economy and beneficiaries of a weaker sterling.

About half the market is represented by consumer staples, financials, energy and healthcare companies.

These typically prove more resilient during periods of higher inflation and rising interest rates, compared to high-growth sectors like technology that are more sensitive to these economic conditions.

Technology companies represent more than a quarter of the S&P 500 in the US, but just one per cent of the FTSE 100 in the UK.

New Prime Minister Rishi Sunak is the British Conservative Party’s fifth in less than seven years.

Hopefully he can keep the UK largely out of the headlines for the balance of the year, and focus on rebuilding the trust and credibility that’s been eroded over the past two months.