Last week saw the UK get a disinflationary boost. Better than expected economic data boosted UK assets. UK small and mid-cap equities rose 3.2% while UK bonds rose as the 10-year gilt yield dropped 10bps to 4.43% (prices rise when yields fall).
UK gilts have performed strongly over the last couple of weeks, with the 10-year yield falling from 4.75% since 9 October.
Expected rate cut
September’s inflation data released on Wednesday was the main boost for markets as monthly price growth came in flat, slowing from 0.3% in August. UK inflation came in lower than expected across the board, prompting markets to raise expectations for BoE rate cuts. The market quickly priced a 70% probability of a rate cut by December, up from 40%.
September – inflation peak?
At 3.8%, annual inflation remains well above target, but economists – including those at the BoE – believe September marked the peak for UK inflation this cycle, with a more consistent downward trajectory ahead: down to 3.4% by year-end and around 2.5% by the end of 2026, with a sharper slowdown starting in spring next year.
With inflation now on track to fall further, thanks to cooling demand in the services sector, the risks of another inflationary flare-up in the short to medium term is fading. That said, it’s not off the table, especially if energy prices rise.
Brighter outlook for UK equities
UK equities responded to this brighter economic outlook. Domestically focused small and mid-caps led the way, supported by cheaper valuations, easing inflation and the hopes of interest rate cuts. Cyclical sectors outperformed, with energy leading the way thanks to a sharp rise in oil prices (oil remains -11.4% lower on the year after rising 7.6% last week). The mood was further lifted by a surprise jump in retail sales, giving investors more confidence in the outlook.
UK fiscal outlook
The UK’s fiscal outlook remains a challenge, acting as both a drag on growth and a force keeping inflation in check. The government’s current approach – raising taxes without tackling long-term spending pressures – is dampening economic momentum and work incentives, which in turn helps ease inflation. Some economists argue the UK may be on the wrong side of the ‘Laffer curve’, where higher taxes start to reduce overall tax revenue. Even US economist Arthur Laffer himself commented last week on SpectatorTV that the UK is “taxing itself to death.” With the Autumn Budget just weeks away, fiscal policy will be a key driver for UK bond markets in the near term.
US smaller disinflationary boost
With the ongoing federal government shutdown, the flow of official data has slowed to a trickle. Still, last week’s delayed September inflation report offered some good news: headline CPI rose 3.0% year-on-year, while the more persistent services component showed welcome signs of disinflation. The release sparked a rally in equities and a drop in Treasury yields on Friday.
The Fed, which meets this week, is widely expected to cut rates. US interest rates have dropped sharply in recent months, but there’s still uncertainty about where inflation is heading – especially if the Fed cuts rates quickly under political pressure.
By Tom Hibbert, Multi Asset Strategist at Canaccord Wealth
