Archived News 05/08/2016
Bank of England reduces interest rate
The economists at the Bank of England have updated their forecasts for the UK economy. They now believe that, in the coming year UK economic growth will slow sharply, unemployment will rise, house prices will fall and consumers’ purchasing power will be impaired as imported inflation takes its toll.
In order to minimise the impact created by the uncertainty engendered by the ‘Leave’ vote in the UK referendum, the Monetary Policy Committee (MPC) has enacted further monetary policy easing, cutting interest rates to their lowest ever level and implying a further cut is probable, instructing the Bank of England to print yet more money to purchase gilts, and non-financial investment grade corporate debt as well. In addition, a new ‘term funding scheme’ has been created in an effort to ameliorate some of the negative impacts on bank profitability stemming from the cut in interest rates.
The initial reaction has seen asset prices rise and Sterling fall as the Bank of England joins the European Central Bank in an all-out attempt to support asset prices in the face of a poor economic outlook.
The economists at the Bank of England ...now believe that, in the coming year UK economic growth will slow sharply, unemployment will rise, house prices will fall and consumers’ purchasing power will be impaired as imported inflation takes its toll.
The reduction in the interest rate from 0.5% to 0.25% is understandable given the impaired economic outlook and the need to be seen to do something and, in this context, the attempt to support bank profitability is welcome. However, we doubt that the impact of the interest rate cut on the real economy will be particularly meaningful.
We are more perplexed by the MPC’s decision to initiate a further round of quantitative easing (QE) or, in layman’s terms, to print more money. QE is an extreme monetary policy and should only be enacted in extremis. By this, we mean when a severe recession looks as though it may turn into depression (as it did in the latter stages of 2008). Given the Bank of England is still forecasting economic growth next year, we are nowhere near that point.
The QE program is designed to drive down Gilt yields and the cost of debt for investment grade companies. It forces investors with a need for yield to invest in riskier assets in order to maintain income. This dynamic should, therefore, help reduce the cost of debt for riskier companies. The belief seems to be that this then releases a wave of investment by companies as they access the cheaper funding. This is all very well in theory, but there is a real problem. Financing costs for companies with access to the bond market are already very low and this hasn’t prompted a wave of investment-led activity. Indeed, evidence suggests that some companies are taking advantage of the very low borrowing costs to raise debt in order to buy back shares. This makes those companies more, not less, susceptible to economic shocks.
Indeed, evidence suggests that some companies are taking advantage of the very low borrowing costs to raise debt in order to buy back shares. This makes those companies more, not less, susceptible to economic shocks.
Another consequence of this policy is that company pension schemes' deficits will continue to widen. Companies will be expected to inject a greater share of the cash they generate into their pension schemes, thus reducing the potential to invest.
Recent conversations with banks lead us to believe that, given the poorer outlook for the UK economy they will be more choosy as to which companies they will lend to, and so it is unlikely that smaller companies will see improved lending terms from banks as a result of the actions of the MPC. It is also worth considering that there is little evidence of pent up demand from companies to borrow from banks.
By conjuring money 'out of thin air', the value of each existing unit of currency is diminished, due to the increased supply and this then prompts currency weakness. Given Sterling has already been very weak, the spectre of imported inflation is very real and will diminish consumers’ disposable income. Whilst the manufacturing sector will benefit from currency weakness, the size of the country’s manufacturing base is dwarfed by the domestic service sector and so we are at a loss to understand why policy makers would want to promote further currency weakness.
In summary, we believe that the actions of the MPC, in the round, will support asset prices, but the jury is certainly still out as to whether the latest round of QE is in the economy’s long term interest. We expect the next step to be that the government will follow through with fiscal stimulus measures in the autumn.
In summary, we believe that the actions of the MPC, in the round, will support asset prices, but the jury is certainly still out as to whether the latest round of QE is in the economy’s long term interest.
Our UK equity portfolios have a healthy exposure to companies that benefit from Sterling weakness and we have also invested in companies that will benefit from a pick-up in infrastructure spend. However, we continue to shy away from ‘expensive defensives’ but acknowledge that they could be supported in the short term.
Whilst the positive impact of the QE program on Gilt and investment grade credit prices is self-evident, the prices of other income producing assets such as high yield credit and infrastructure should be well underpinned.
Chief Investment Officer