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Are we at the end of the Great British Sell-Off?

One of my favourite movie lines is from Annie  Hall: “Life is divided into the horrible and the miserable.” Given how horrible the rout in UK equity, bond and currency markets was last week, investors could be forgiven for feeling nostalgic about the past few years of weakness – when, in Woody Allen’s terms, we were lucky enough to be just miserable.

The relative cheapness of UK equity markets has been an oft-visited theme for much of the past six years. Similarly, over any longer-range timeframe, sterling has looked attractive from a purchasing power parity basis. Until this year only bond markets were the exception. This has clearly changed – which explains why, as prices have adjusted, portfolios holding bonds to guard against capital losses have experienced the opposite.

It is not just that this has been the last shoe to drop. With the new Chancellor’s fiscal package offering food for every sore-headed bear, the recent spike in bond yields has also triggered a new wave of selling.

We are undoubtedly in “horrible” territory, but that is when investors are taught to be their most aggressive. How near are we to the end of the ‘Great British Sell-Off’? And what – to quote one of our fixed income investors – could be the ‘circuit-breaker’ that shakes the markets out of their funk?

Let’s start with the first question. Experience of different market cycles can help us identify points at which negative sentiment overwhelms – when the thrown-in towels have piled up and the case for further losses just sounds smarter and better-informed. I have felt some of this in reviewing some of the coverage of the new government’s economic plan.

In summary, the market is saying that adding extra stimulus to an economy with little spare capacity is negative for inflation and hence will require policy rates to adjust dramatically. As mortgage rates rise, along with broader living costs, this will push the economy – which, according to many, is already in recession – into a deeper slump. The lack of fiscal responsibility will see international investors flee, putting further downward pressure on the currency. What is more, this is all an act of political self-harm. Such a clearly poor economic plan is laying the ground for another change of government (and party) around the corner.

What interests me in this analysis is not which part of it is right or wrong but how hard it is for all of it to be true concurrently and to the extent being expressed. How can a deepening economic slump and determined action from the Bank of England not temper inflation sooner rather than later? If the new Tory leadership are, indeed, set to blow themselves up then why is the potential for many of these measures to be unwound in under 18 months not given any consideration?

The fact that there seems almost no case to be constructive on a near-term or medium-term view suggests to me that we are much nearer the end than the beginning of the sell-off and the case to be ‘greedy when others are fearful’ is building.

That brings us to the second and even more interesting question, which is what could lead to that change of view or what would need to happen so that what has been a value trap comes to be seen as a value opportunity.

One thing is for sure: the circuit-breaker that the market has tended to look for at any point of distress over the past 15 years – central banks committing to injecting liquidity into the system – will not materialise. The Bank of England’s intervention last week to shore up bond markets was a limited and targeted one, and the Bank remains committed to reversing quantitative easing.

The more likely circuit-breaker is compelling evidence that the real economy is performing much better than currently feared. There is actually a good chance that this will prove to be the case – maybe in spite of rather than because of the new economic measures. The facts of full employment, a high level of household savings, a banking sector with a greater capacity to lend (even if the mortgage market is in temporary turmoil) and a corporate and government sector with an imperative to invest should all be supportive.

In previous years the market mistook easy monetary policy and booming asset markets as signs of a robust underlying economy. As a result, it had a propensity to price in higher corporate earnings growth at the start of the year, with this growth then progressively downgraded as we went through the year. We were over-optimistic. Today the market risks making the opposite mistake.

The other circuit-breaker that could be more in evidence is a wave of corporate activity. We have already started to see an increased level of bids for good-quality UK-listed companies whose valuations are now even more attractive thanks to the fall in sterling.

Constructing a positive case is always a challenge in market environments like this, but it is a challenge long-term investors should take up. Past cycles teach us that turning points in market bottoms tend to be sudden and dramatic. Catalysts can really be identified only in retrospect. But one consistent factor is that the appetite for the positive case at that turning point is extremely low.

In other words, the best buying opportunities come when it feels horrible and miserable.

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