The Bank of England (BoE) raised UK interest rates for the first time since July 2007. The base rate has increased from 0.25% to 0.5%, but we do not believe this necessarily marks the start of an imminent tightening cycle…
Although today’s is first interest rate hike in over a decade, the forward guidance provided is arguably of greater importance to investors…
Today’s increase has been expected for some time, with positive economic data and rhetoric from BoE policymakers having led investors to price the move into asset markets ahead of the event. However, the Monetary Policy Committee’s (MPC) accompanying communication included the publication of an estimate of the economy’s potential growth which, at 1.5%, was lower than market expectations. The MPC also refrained from stating that rates could rise more quickly than the market expects in the future, as it had in the communication accompanying its last meeting in September. In line with this, Governor Carney also maintained his narrative that the path of monetary policy is dependent on the progress of the economy, which remains highly uncertain as a result of Brexit, and stopped short of stating that today’s move meant that the BoE had embarked on a rate-hiking cycle.
…the BoE’s views on growth potential and uncertainty explain today’s market reaction
While the MPC’s inflation projections remained broadly unchanged, these developments led investors to price a lower probability of further interest rate rises into asset markets. This manifested itself in the form of declining short-term gilt yields and a lower sterling. In turn, sterling’s decline supported UK equity markets. Given the effect of sterling exchange rates on their translated foreign-currency earnings, it was unsurprising to see large-cap, UK-based multinational companies generally outperform their mid and small-cap, domestically-focused peers.
The economy’s resilience has allowed the BoE to remove some of the additional stimulus it provided after last year’s Brexit referendum
Rate hike not necessarily the start of a tightening cycle
Although UK growth has slowed since the Brexit referendum, it has remained positive and exceeded the government’s and BoE’s projections. Furthermore, the labour market has continued to strengthen, with the unemployment rate having fallen to lows not seen since the 1970s (Figure 1). While domestic demand has remained resilient, both of these trends have been helped by sterling’s devaluation boosting the international competitiveness of UK-based businesses.
UK growth, unemployment and interest rates
Figure 1: The UK’s economic growth rate has remained resilient since Brexit, while unemployment has continued to decline. This has justified the BoE’s decision to reverse the interest rate cut it implemented after the referendum last year*.
However, the economy still faces Brexit-related headwinds
Although these statistics indicate that the UK economy remains robust, we do not believe today’s decision necessarily signals the imminent start of a rate-hiking cycle. Rather, the BoE has simply reversed the emergency cut made in anticipation of a growth slump following the referendum last year. Sterling’s devaluation has increased cost-push inflation, whereby the cost of imported good and raw materials has risen. Meanwhile, structural factors such as globalisation, technological change and demographics have prevented wage growth from accelerating (Figure 2). Together, these factors have pushed real wage growth into negative territory and this is weighing on consumption growth, a key driver of broader economic growth in recent years. This is evidenced in the declines of consumer confidence and household spending growth. Furthermore, household debt is increasing, both as a percentage of GDP and relative to peoples’ incomes. In particular, the fast rate of consumer credit growth has been of concern, with the trend of deleveraging that followed the global financial crisis appearing to have reversed (Figure 3).
Sterling, inflation and real wage growth
Figure 2: As sterling has depreciated, inflation has risen as the cost importing goods has become more expensive. This has put pressure on real wage growth (wage growth adjusted for inflation). It is uncertain how long the squeeze on real incomes will last, but it typically taken between one and two years for the effects of similar currency debasements to pass through the economy via inflationary pressures, notwithstanding any further large moves in foreign exchange rates*.
The UK consumer
Figure 3: The decline in real wage has put pressure on the UK consumer. This is evident in the fact that the savings rate has declined, while household debt has begun to increase relative to incomes*.
Despite higher inflation, we do not believe further rate hikes are imminent
Although higher inflation could coerce the BoE to raise rates, the primary goal of such an occurrence would normally be to stop the economy from overheating. This would generally be the case when demand factors are pulling inflation higher, rather than when it is being driven upwards by cost rises from overseas. Currently, however, the latter is occurring. With domestic consumption growth facing a slowdown, it is unlikely that the BoE will raise interest rates much further in the near future.
Over the medium term, the Brexit negotiations will play a key role in determining the BoE’s policy stance
Although it appears that some progress is being made in terms of the Brexit negotiations, little clarity has been provided on key aspects of the UK’s relationship with the EU after it secedes; for example, in terms of immigration and trade. There is potential for UK growth to disappoint if the Brexit process progresses worse than expected. Such a scenario could weigh on sterling, exacerbating inflationary pressures and causing firms to delay or abandon investment plans, weighing on growth. In this situation, today’s decision to raise rates will likely be retrospectively considered as a policy error.
There is still scope for a better-than-expected economic outcome
Nevertheless, the BoE has opportunistically taken the decision to send a message that the economy is progressing better than had been expected, potentially helping it maintain its goal of price stability through improved sentiment towards sterling. If the Brexit negotiations progress well, the boost to economic and investor sentiment would likely increase companies’ propensity to invest, supporting growth. We would also expect such developments to be extrapolated by foreign-exchange markets via an appreciation of sterling; this would weigh on inflation and reduce the pressure on domestic consumption. Such a scenario could allow the BoE to take a more hawkish monetary stance in time.
UK economic activity
Figure 4: Economic activity, as measured by the UK’s purchasing managers’ indices, has recovered and held up well since dipping after the Brexit referendum (a reading over 50 indicates expanding activity, below 50 represents contraction). The exception has been the relatively small UK construction sector, which has moved into contraction in recent months amid concerns over longer-term demand for office space. The ongoing Brexit negotiations will go a long way to determining whether this weakness will eventually spread to the much larger UK service sector, but we are encouraged that it has so far shown resilience*.
Although we are cautious on the economy’s prospects, the UK stock market will still present opportunities
UK equities still present opportunities
Although the unprecedented nature of Brexit makes predicting the economic impact hard, both in terms of consumption and investment, we are encouraged that the economy has so far performed better than had been expected. Despite this, economic data is pointing to a slowdown, predominantly in terms of consumption, and we are therefore cautious on the UK economy’s prospects, particularly relative to overseas markets which we have judged to present similar or better opportunities alongside lower risk. Nevertheless, the UK equity market’s make-up and structure will ensure that opportunities remain for investors, whatever the macroeconomic outcome. It will be important to distinguish between different areas of the market and individual companies; this will make stock selection a key driver of returns.
Sterling volatility will be a key factor in determining the relative performance of domestically-focused and internationally-exposed stocks
UK-based multinationals derive benefit from sterling’s devaluation, while they often hold only limited exposure to the domestic economy. Therefore, they could benefit if the UK economy performs worse than expected. Conversely, domestically-orientated companies will likely outperform if Brexit clarity is gained and/or the economy performs better than expected. We note that in either case valuations are particularly important, as pessimistic macroeconomic expectations can lead individual companies with strong prospects to be undervalued and vice versa.
This article was first published on the Brookes MacDonald blog 0n 2nd November 2017.
*Source: Thomson Reuters Datastream