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Banking On Economic Recovery

04 Aug 2016

Ahmer Tirmizi, Research Analyst

The Bank of England cut interest rates to 0.25%, the first change since March 2009, and announced a raft of other monetary measures to ensure the UK economy doesn't spiral into a recession. We provide an update on the news and our portfolio positions.

In order to engineer an economic recovery, central banks have been allowed to dabble in a plethora of extraordinary policy measures (quantitative easing (QE), negative interest rates, private sector asset purchases etc.) since the financial crisis. They are kept in check by two constraints: 1) keep growth on a steady path, close to what economists call ‘potential growth’ and 2) maintain inflation around a target, usually 2%. It is these constraints which posed a dilemma for the Bank of England (BoE). The most up-to-date business and consumer survey data shows a sharp contraction in confidence, following the Referendum, which points to a potential recession in the second half of this year. However, the sharp fall in the Pound means the UK economy is likely to see inflation rise beyond the BoE’s inflation target in the coming year. For this reason, markets were not expecting much from today’s announcement beyond a modest rate cut.Bank of England has decided to throw caution to the wind by announcing the following measures.

Despite this, the BoE has decided to throw caution to the wind by announcing the following measures: cut the base rate from 0.50% to 0.25%; recommence its QE program by buying £60bn worth of government bonds over the next six months – taking total asset purchases to £435bn; join the Bank of Japan and European Central Bank by buying bonds issued by companies to the tune of £10bn over the next 18 months; and launch a new Term Funding Scheme (TFS). The TFS is designed to incentivise banks to lend more to the economy, with the BoE lending to the banks at close to base rate. The immediate market reaction has seen the Pound fall over 1% against the major currencies while 10-year UK Gilt yields touched new lows intra-day. Unsurprisingly, UK equities markets welcomed the announcement with both the large and mid-cap indices ending the day over 1% higher.

The BoE acknowledged the fall in the Pound will see inflation rise but have stated they are willing to look through their 2% inflation target in order to cushion the economic fallout from the Referendum. To this end, they have signalled they could cut rates to zero by the end of this year. Despite surprising markets, we doubt this series of measures will do much to stimulate the economy. For instance, the proportion of the population that holds a mortgage has fallen to just 30%, from 40% a decade ago. Meanwhile over half of all mortgage borrowers are now on fixed-rate schemes, up from a third three years ago. It is hard to see how such a modest fall in interest payments can offset the recent sharp fall in business and consumer confidence.

This is not to say the economy cannot surprise on the upside over the next few months. Compared with other asset classes, the currency markets are painting a particularly gloomy picture for the UK, so any positive surprises from here could see the Pound rally. Because of this we continue to favour holding Sterling – which has seen us move our foreign currency exposure (in our Balanced portfolios) from 48% before the Referendum to 32% now.

Ahmer Tirmizi
Research Analyst

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