InvestmentsAug 18 2016

Has BoE run out of ammunition?

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Has BoE run out of ammunition?

The Bank of England (BoE) delivered an aggressive easing package at its August meeting, cutting interest rates by 25 basis points, reopening quantitative easing (QE) – including both gilt and corporate bond purchases – and unveiling a new Term Funding Scheme to provide cheap funding to banks.

These measures came in above market expectations, demonstrating the Monetary Policy Committee’s determination to restore confidence and avoid economic recession in light of the recent Brexit vote.

The outlook for the UK economy has taken a significant hit following the EU referendum, with recent survey data indicating a potential recession.

Business confidence indicators have fallen sharply, with the July Purchasing Managers’ Index reading consistent with close to a 2 per cent annualised contraction in the economy, as Chart 1 shows.

It is tempting to assume this process will be protracted, requiring monetary policy easing to support the economy in the face of related uncertainty for an extended period of time Anna Stupnytska

Consumer confidence has also slumped, hiring has slowed, and the housing market is showing signs of a downturn.

Whether this negative survey evidence fully translates into hard data over the next few months remains to be seen.

In this respect, while some easing action from the BoE was clearly justified given the political turmoil in the UK and the associated uncertainty for investors, such a big package delivered in August seems somewhat hasty.

Chart 1: UK business confidence falls pointing to a potential recession

Source: Markit, ONS; Haver Analytics, August 2016

Part of the loosening in financial conditions required to cushion the Brexit shock has already occurred through the large decline in bond yields and a 9 per cent depreciation in trade-weighted sterling. Essentially, markets have done part of the easing job for the BoE already.

The BoE could perhaps afford to have waited a bit longer to assess the extent of damage to the economy and to gauge the appropriate response.

Key Points

The Bank of England cut interest rates by 25 basis points at its August meeting and reopened quantitative easing.

Part of the loosening in financial conditions required to cushion the Brexit shock has already occurred.

The pound continues to bear the brunt of Brexit, weakening further following the announcement.

The downside of going all out on easing so soon is that these measures do not come without their own downside risks.

Given that little is known about the Brexit negotiations, including the timeline and substance, it is tempting to assume that this process is likely to be protracted, requiring monetary policy easing to support the economy in the face of related uncertainty for an extended period of time.

The transmission mechanism from QE to the real economy remains questionable and there is evidence to suggest its effectiveness diminishes over time. The danger here is that the BoE might find itself out of existing ammunition quite soon, with markets putting further pressure on the BoE to do more.

This might be seen as the ‘Draghi’ trap, where aggressive easing drives a continuous need to ever more greatly surprise markets with policy action to the upside.

In terms of investment implications, the pound continues to bear the brunt, weakening further following the announcement. Given the policy-easing bias in combination with a large current account and fiscal deficits, it is reasonable to expect further currency weakness.

Short pound positioning is already at extreme levels, however, making the currency susceptible to sharp reversals driven by short covering or indeed by any change to the BoE’s dovish stance. This makes overseas assets relatively attractive for UK investors.

While bond yields have also seen significant falls lately, the potential for a further extension of government bond purchases, as well as a putative cut in interest rates to 0.1 per cent, means further declines are likely.

This is particularly the case at the long end, resulting in more curve flattening. The corporate bond buying programme should in turn lead to further spread compression in sterling credit as well as further deterioration in credit market liquidity.

This makes bonds a relatively attractive investment compared to near-zero yielding cash, although absolute returns will be very low and indeed negative in real terms.

While more accommodative action from the central bank is typically good news for equities, UK company fortunes will diverge depending on their domestic versus external exposure.

Significant currency weakness should be good for exporters while importers and more domestically oriented companies will suffer, particularly in the environment of falling real incomes. Differentiation across sectors and currency exposure is thus crucial for equity investors.

Property market investors will be in for a more difficult time than they have been used to. The Royal Institution of Chartered Surveyors’ housing market survey shows that chartered surveyors’ expectations for house prices are deeply negative, and at their lowest since 2012.

Price falls may be exacerbated in London and the South East, where housing valuations are highly stretched relative to rental incomes and local wages, and where foreign investor flows have supported the markets to a greater extent in recent years.

Commercial property values have also taken a hit, with CBRE data showing they lost 4 per cent of their capital value in July alone. However, relatively attractive rental yields in many sectors should support returns.

Of course, the EU referendum vote and resultant uncertainty have created a large supply-side shock, and monetary policy alone cannot come close to fully offsetting this.

Despite the BoE’s actions, and its ability and willingness to maintain supportive financial conditions for now, fiscal and structural policies will have to step in to help navigate the UK economy over the medium-term.

Fiscal stimulus in the form of infrastructure investment and measures to boost consumer spending and business investment, perhaps involving tax cuts, would go some way towards limiting the Brexit fallout in the short-to-medium term. All eyes will now shift to the Chancellor’s Autumn Statement.

Anna Stupnytska is global economist at Fidelity International