Brooks Macdonald Update

Having raised rates for the first time in a decade back in November, the Bank of England (BoE) today increased the UK Base Rate for a second time this cycle, as widely expected, from 0.50% to 0.75%. Nevertheless, there was a hawkish spin on the accompanying communications, with the surprises of a unanimous vote by the Monetary Policy Committee (MPC) to raise rates and the BoE raising its growth forecasts.

Furthermore, the estimate of the neutral interest rate provided in the BoE’s accompanying Inflation Report exceeded expectations at 2.00%-3.00% (consensus expectations were for 1.75%-2.50%). This was arguably of more interest, given its implications for the future path of interest rates; Governor Carney, however, was keen to downplay the estimate’s importance, given that it is based on assumptions than can change sharply over short timeframes and that he viewed external inflationary pressures to be easing.

The neutral rate is the rate at which the BoE believes it can keep inflation around its 2% mandate target level, while allowing the UK to achieve its longer-term economic growth potential. It will help determine borrowing costs for consumers and corporates over the longer term, as the BoE is expected to raise the Base Rate to the level of the neutral rate over the next two to three years (the BoE’s forecast horizon).

Context: what drove today’s events?

The first rate hike in this cycle, undertaken in November, simply reversed the emergency cut made in anticipation of growth slumping following the Brexit referendum in 2016; it was implemented as the economy was performing better than BoE had expected. Since then, a bout of weaker-than-expected economic data caused UK policymakers to keep rates on hold. However, this retrospectively appears to have been driven, at least in part, by transitory factors such as adverse weather conditions. Indeed, the recent improvement in economic data caused the MPC to raise its growth projections.

Nevertheless, growth currently remains weak and although inflation has fallen faster than expected following the import-cost-driven surge that resulted from sterling’s large depreciation after the referendum, it has stayed reasonably sticky. This has kept real wage growth very low, despite a marginal improvement over the past few months. Counterintuitively, there is an argument that higher interest rates could support growth by strengthening sterling, thereby alleviating some of the pressure that weak real wage growth is putting on consumption. It is important to recognise that today’s hike has only taken the Base Rate 0.25% above the ultra-low levels put in place following the global financial crisis. The BoE has therefore judged the benefits of more hawkish monetary expectations to outweigh the adverse economic impact of slightly higher borrowing costs.

The MPC’s decision was likely also influenced by the fact that they are uneasy with the loose level of monetary policy at this late stage in the economic cycle. Policymakers will be cognisant that the opportunity to raise the Base Rate to its neutral level may be taken away by external factors, such as a US recession, which is expected to occur within the next three years, according to consensus estimates. Such a situation would leave them less able to deal with any future recession in the UK.

Market reaction

Unsurprisingly, given the hawkish nature of the MPC’s accompanying statement, sterling jumped following the announcement. However, it sold off after Governor Carney’s press conference downplayed the importance of the neutral rate and is currently trading lower. UK equities had sold off from near all-time highs in the days prior to the event, but they found support as sterling lost ground. Like sterling, gilt yields spiked higher after the news was released, but immediately retraced and traded lower amid risk aversion.

Our view

Over the next 12 months, the UK economy will continue to face the same headwinds that have supressed growth in recent years. We recognise that some consumption data has improved recently, but this is likely the result of temporary factors such as hot weather in the second quarter, England’s performance in the World Cup and the royal wedding. Overall, real wage growth will remain under pressure and it is likely that the MPC aimed today’s decision at alleviating some of the pressure on consumption. Meanwhile, political uncertainty will continue to weigh on corporate sentiment and investment. Although it appears some progress is being made in the Brexit negotiations, little meaningful post-Brexit clarity has been provided in key areas such as trade. The risks associated with a last minute Brexit deal (or no deal) remain and productivity growth is expected to remain low, as recognised by the Office for National Statistics (ONS) in last November’s budget.

Conclusion

We hold a neutral outlook on UK equities and today’s events have not changed this view. Although the outlook is pressured by the overhangs of relative economic weakness and political uncertainty, valuations largely reflect this (even considering the fact that the market has heavy exposure to the resource and energy sectors, which naturally weighs on its valuation). We have recently upgraded our view on gilts, which are likely to benefit from episodes of risk aversion associated with Brexit-related uncertainty, growth scares, or politics, given that there is a risk of a leadership challenge and/or a change of government. These factors will also continue to influence sterling exchange rates and volatility, which will ultimately create opportunities for active managers to buy and sell assets at attractive prices.

Investors should be aware that the price of investments and the income from them can go down as well as up and that neither is guaranteed. Past performance is not a reliable indicator of future results. Investors may not get back the amount invested. Changes in rates of exchange may have an adverse effect on the value, price or income of an investment. Investors should be aware of the additional risks associated with funds investing in emerging or developing markets.

The information in this document does not constitute advice or a recommendation and you should not make any investment decisions on the basis of it. This document is for the information of the recipient only and should not be reproduced, copied or made available to others.

Brooks Macdonald is a trading name of Brooks Macdonald Group plc used by various companies in the Brooks Macdonald group of companies. Brooks Macdonald Group plc is registered in England No 4402058. Registered office: 72 Welbeck Street London W1G 0AY.