Monthly Commentary October 2017
Will rates continue to rise?
The previous increase in the UK policy rate occurred so long ago that it may well have been a different world. In many ways it was. In July 2007 the economy was growing at 3% a year, inflation had been within the Bank of England bandwidths for years, RBS was still privately owned and Tony Blair had only just resigned as UK Prime Minister. Nobody really thought that leaving the EU was ever going to happen and the idea that Leicester City may one day win the Premier League was preposterous. 10 years down the line the outlook is very different. RPI inflation is at 4%, growth is at 1.5% and there is uncertainty about both Brexit and Leicester City (some things at least remain constant)
The bond market expected an increase in policy rate on Thursday. This time the prediction was correct, but this is not always the case. In June the probability of a rate rise rose to 50%; before the EU referendum there was also a solid expectation of rate rises and in 2014 as the economy was recovering there was also an expectation that policy would slowly be normalised. Given the economy is arguably weaker now than at any time over the last 4 years why now is the MPC raising rates?
Firstly and perhaps most importantly the market (and Kempen) believe that the newly announced policy rate increase is likely to be the first and last for some time. We are not about to embark on the sort of policy normalisation seen recently in the US. There is no doubt that the BoE is tightening into weakness but there are legitimate reasons for a policy rate increase.
Inflation is above the Bank of England’s target and is widely expected to continue to be so for some time; there is only so long that this can continue until credibility comes into question. The labour market is strong with unemployment at historically low levels and employment at historically high levels. The BoE believed that the balance of risks lay with employment not being hurt by a limited increase in policy rate, as made clear in the Governor’s supporting statement.
The BoE is also clearly worried about credit creation with personal debt increasing significantly over recent years. Having demanded that banks increase capital provisions the next logical step is to increase the price of money.
Also it must be remembered that the rise is simply undoing the cut following last year’s referendum. Whilst the full impact of that decision is yet to be felt the impact of the referendum vote was not as bad as had initially been feared.
“It must be remembered that any rise would simply be undoing the cut following last year’s referendum”Robert Scamell, Senior Portfolio Manager
In addition one has to contemplate what could have happened if the BoE did not increase the Bank Rate. Given the market was pricing in a near 90% probability of a rise, a failure to do so would likely have resulted in yields falling, sterling falling and thus inflationary pressures rising again. In reality, yields in rate markets did fall slightly, as did sterling.
There are certainly members of the MPC who have their doubts as to whether the exchange rate driven inflation we have seen warrants a rate rise in the face of such uncertainty about the economy and it may well be that these voices prevail in future. Thursday’s vote showed 7-2 in favour of an increase in the Bank Rate. The market consensus was 6-3 in favour. No one is right all the time.
What does this mean for UK pension funds?
Nobody should get too carried away by the move The increase in policy rate had little impact on the long-term yields that are so important for pension funds – the 30-year yield fell by 0.03%. One increase in the policy rate does not signify the start of a tightening cycle and yields will likely remain at low levels for some time. We are not about to get up to 5% rates any time soon. As always, a sensible and balanced approach to risk is appropriate.
UK policy rates: Source: Bloomberg.
Sold in May and went away
So goes the old stock market adage. This year it would have hurt you as equity markets have been soaring to all-time highs, powering through to St Leger’s Day on the back of Big Tech. But it’s not just the US that’s had a great summer; Emerging Markets have been the star performer, adding more than 20% YTD, and Japan added more than 10% in sterling terms (the latter adding most of its gains following the very recent decisive election victory for Shinzo Abe and the LDP) – and all this amid the tensions with North Korea and the fresh political risk of Catalonia.
Doesn’t this feel a bit like the dotcom bubble?This time isn’t completely different, but it really isn’t the same as the dotcom bubble – the rally in Big Tech has been far more modest than what we saw in 1999, and underpinned this time by strong earnings. Japan appears to be benefiting from Abenomics in a remarkable way; inflation is starting to appear at long last and the electoral victory should lead to substantive progress in the structural reform element of the policy. US markets have performed strongly, with valuation multiples relatively high, yet this appears driven by global growth expectations and decent corporate earnings rather than expectations of a Trump tax(cut) windfall. Emerging markets have benefited from the weakening dollar as well as strong improvements in fundamentals. So whilst we are seeing strong performance, it doesn’t quite bear all the usual hallmarks of a bubble. Yet.
If not now, then when?
The chorus of bubble bursting doomsayers have grown louder with each new high, gleeful in their certainty that the bursting of the great bubble is just a news cycle away. Well they have a reason to be gleeful – they are right. Technically. A bursting of some kind is inevitable at some point. As a much wiser person once said, give them a prediction, or a date, but never both. The gloomy outlooks fall into this category – the only certainty you can take away is that if they’re ever right, they’ll never let you forget it, and of course it would happen at that particular moment, with all the clarity of hindsight.
The Eurozone continues to show improving growth, sufficient to provide the ECB some room to reduce its pace of QE activity. The UK has been – by a large margin – the weakest major equity market this year, held back by an uncertain political outlook (read Brexit) and just as murky an economic outlook; expectations of a rate rise from the Bank of England have supported Sterling against the other major currencies, which has an inverse relationship to the UK stock market where a majority of earnings come from overseas. Should these rate rises materialise, this should provide some respite for pension schemes whose liabilities are pegged to gilt yields, though unless they are dramatically larger than expected, those articles in the press touting the wiping away of deficits are a tad optimistic in my view.
So how does this impact our clients?
Timing matters. Especially when it comes to decisions not to be in the market; you might feel a little better about being underexposed at the next turn, but you’ll be impacted far more by the cost of being out of market over the long term. In these markets, a strategic mindset trumps the reliance on tactical and dynamic trading that has taken hold of some pension schemes in recent years through the over-reliance upon some Diversified Growth Funds, particularly in extreme cases where all strategic asset allocation decisions have been ceded to these managers with much shorter term mindsets than the pension scheme investors.. Whilst we see better value in some equity markets than others and have positioned between regions and styles, we still prefer equities over bonds for the moment and have structurally and meaningfully tilted our clients accordingly.
Staying the course can be messy, it can be volatile (though not this year-to-date – it’s been pretty smooth sailing), and it can be immensely difficult to do nothing. Sometimes it is right to let the wind carry you and ride the waves a little further, and so far this year staying the course in equities has – yet again – beaten all comers.
[You’ll note I didn’t give a date either, lest I suffer the fate of Leger.]