U.K. inflation drops below 5.00%, core shows stubbornness

Market update

Economic news

• October headline CPI came in at 4.60%, down from 6.70% in September — continuing its downward trajectory over the past quarter.
• The fall in core CPI was not as pronounced. October core CPI was 5.70% compared to 6.10% for the prior month. This was driven by a material drop in goods inflation at 2.90%, down from 6.20% in September.
• The labour market data is showing a cooling trend, but remains tight:
  • September unemployment rose marginally from 4.20% to 4.30%.
  • Average earnings, excluding bonuses, slowed to 7.70% in the third quarter of 2023, having peaked at 7.90% two months earlier. Including bonuses, the figure slowed to 7.90% compared to a record 8.50% in July.

• Energy prices were a major influence on the headline print. This was largely a base-effect story, with higher levels for oil in the middle of 2022 influencing the year-over-year comparison. Brent reached highs of c. $130/b in the first half of last year. Current levels of $80-85/b are low by comparison, which is driving down headline CPI. It is notable that inflation volatility has been increasingly dependent on energy and fuel prices compared to other cost categories.
• Brent year-over-year fell more in October compared to November year-over-year, and futures markets expect prices to hold at current levels over the short-term. This would translate into further downward pressure on headline CPI but to a lesser extent in the coming months.

Sterling rate markets

• Over the past fortnight, the gilt yield curve and the SONIA swap curve decreased by 15 basis points for medium tenors, with a 25-basis-point drop in the long end of the curve.
• This was partly reactive to the U.K. inflation data release. However, there was also some sell-off post U.S. inflation release.

• Since the November Monetary Policy Committee meeting, there has been a significant sell-off in gilts. The curve has come in c. 30 bps from four years onwards and more than 40 bps on the long end of the curve from 20 years.
• This has brought down the elevated yields in the middle of the curve, which had been hovering at c. 5.00%, down to c. 4.50%.

• As core CPI remains sticky and is arguably a more relevant metric for the Bank of England, rate cuts are unlikely to come in any time soon.
• However, markets are pricing in rate cuts in either June or August 2024.

• In the U.S., falling headline 3.20% and core 4.00% inflation data continue to fuel optimism around the end of the hiking cycle for the Fed and reinforces the expectation the economy could be headed for a soft landing. Annualised quarterly GDP growth at 4.90% is significantly ahead of other developed country peers.

Capital markets - sterling issuance

• While new housing association (HA) bond issuance remains relatively quiet, there have been a few recent capital markets transactions in the secondary HA market as well as related sectors with encouraging issuance implications.
  • AHGS (‘Aa3’ Moodys) sold £70 million of their 4.809% Guaranteed Secured Bonds due 2053 at UKT+43. This represents an all-in rate of just under 5.25%.
  • Southern Housing has also sold £150 million of their 3.283% due 2048.
  • Northern Powergrid (‘A’ S&P / ‘A’ Fitch) issued £250 million 5.625% ‘33 (10-year bonds) at UKT+132 after tightening from initial price thoughts of +150-155 and +135a guidance; the order book was significantly oversubscribed with ~£1 billion in orders (7 Nov). Current indicative secondary spreads have tightened to around UKT+120.
  • London Power Networks (‘A3’ Moody’s / ‘A-’ S&P) issued £300 million 5.875% ‘40 (17-year green bonds) at UKT+125, 20 basis points tighter than the +145a guidance; also significantly oversubscribed with ~£2.1 billion in orders (8 Nov). Current indicative secondary spreads have tightened to around UKT+109.
  • Thames Water (‘Baa1’ Moody’s / ‘BBB’ S&P) priced £300 million 8.25% ‘40 (16.5-year bonds) at UKT+320 last month (18 Oct). Although demand was also strong (~£1.5 billion in orders), spreads were materially wider. Current indicative secondary spreads have tightened to around UKT+275.

• Last week’s NP and LPN pricing not only highlighted investor preference for utilities credits over water/wastewater, but also signal the re-emergence of demand for shorter tenure without substantial spread widening. Both issues were priced on the heels of the BoE’s 2 November decision to hold the bank rate at 5.25%. All have tightened since issuance.

Credit ratings

• Moody's has changed outlooks from negative to stable and affirmed the ratings for 33 housing associations.
• The credit rating agency stated that policy predictability has been restored following heightened volatility last year around the Liz Truss mini-budget. This resulted in a change in the outlook.
• Following this sovereign update, Moody’s changed its outlook for several HAs, raising the outlook from negative to stable for 33 HAs. Moody’s rating of HAs incorporates an uplift based on their assessment of a strong likelihood of extraordinary support from the U.K. government.
• Fitch recently affirmed a majority of the HAs they provide ratings for, with two downgrades and one outlook revision to negative.
• This year, major focus points for credit rating agencies continues to be the balancing of new development and investment into existing homes.
  • This includes an emphasis on flexibility in operations and clear risk mitigations with appropriate responses. Asset disposals are also seen as a funding source.
  • There is an expectation that the rent settlement and easing inflation will create a positive inflationary gap and support HAs financials.

Benefits settlement

• It was announced that the U.K. government is considering using October’s CPI print (4.60%) to uplift next year’s benefits rather than the September figure (6.70%).
• This brings into question whether the government will impose a similar move for rent settlements. If they do not, there will be a disconnect in benefit income versus rent uplifts, which may result in higher arrears for housing associations.
• If rent settlements follow suit, HAs who have entered into inflation-linked instruments indexed to September will see greater inefficiency on these rental income hedges.

Indicative pricing