Analysis-The deep freeze over UK assets is thawing

Britain's stocks and bonds are drawing strong buying interest, not quite a vote of confidence in the economy but a reassuring sign for policymakers that a deep investment freeze in British markets prompted by last year's upheaval has thawed.

London's blue-chip FTSE 100 stock index is hovering near record highs, with the internationally-focused bourse benefiting from global trends such as China's economy reopening from stringent COVID lockdowns.

Ten-year government bond yields are down 27 basis points so far in 2023 to 3.4%, notching one of the biggest falls in government financing rates among the Group of Seven most advanced economies.

It marks a turnaround from the turmoil unleashed by former prime minister Liz Truss' administration's badly received mini budget in September, which briefly pushed Britain's five-year bond yields above those of Italy and Greece as investors took flight.

"This does suggest a possible inflection point in sentiment towards UK assets," said Nick Kissack, a UK portfolio manager at Schroders, which manages roughly $910 billion of client funds.

"We saw extreme levels of risk aversion," in September, he added, while "the risk premium for UK assets has come down since."

Graphic: UK assets bounce back -

FTSE FINDS FAVOUR

The FTSE-100 has bounced 18% from roughly 18-month lows hit in October following the mini-budget, which unveiled historic tax cuts and huge increases in borrowing that were later reversed.

Sterling, has risen around 13% from September's record lows, the domestically-focused FTSE 250 share index is about 20% higher since mid-October.

The FTSE 100, dominated by firms that make most of their revenue abroad, has sailed to record highs as investors also played what Barclays head of European equity strategy Emmanuel Cau calls the "global stagflation theme".

That, in short, is an outlook of higher global interest rates, weak growth and high inflation.

The blue-chip index's largest constituents by weighting are oil and gas groups whose coffers have been swelled by a surge in energy prices in the wake of Russia's invasion of Ukraine, banks that benefit from higher interest rates and consumer staples businesses expected to perform reliably during recession.

Given large mining and materials components, the FTSE has also received a boost from China's economy reopening, moving higher in tandem with Hong Kong's Hang Seng share index.

However, analysts expect the FTSE 100's rise to falter with a stronger global growth outlook combined with waning energy inflation.

"Our clients are wondering if they should...go back to more risk-on markets," said Cau, citing recent upgrades to global economic forecasts.

Graphic: Higher energy prices and interest rates drive FTSE100 -

GILT TRIP

UK government bonds, pummeled by the mini-budget, have proved one of the best sovereign bond buys of 2023, outperforming U.S. and German peers as traders believe a looming UK recession will drag sky-high inflation down.

The Bank of England has softened a previous prediction of a sharp economic downturn but still sees a contraction ahead.

It predicts headline inflation will fall from its latest reading of 10.5% to 3% by early 2024 - an outlook that's enticing back bond investors, whose fixed coupons are eroded by high inflation.

Graphic: Britain's bond market outperforms -

Markets predict the BoE will lift interest rates at least once more from 4%, while the European Central Bank is widely expected to stay hawkish for longer as the euro zone outlook improves.

"The UK is the standout global economy where growth prospects have not improved," said Baylee Wakefield, multi-asset portfolio manager at Aviva Investors, who expects gilts to continue outperforming Treasuries.

Others were more cautious, given burgeoning future supply of gilts as the government rushes to bolster a slowing economy.

"After the recent rally, gilts in general look a bit expensive," said Craig Inches, head of rates and cash at Royal London Asset Management.