Thoughts through the cycle: W5 January ’20

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The UK

  • Today, the Bank of England’s Mark Carney presided over his last Monetary Policy Committee (MPC) meeting before Andrew Bailey takes over as Governor. The UK base rate remains unchanged at 0.75%, despite the odds interpolated from the futures market going into the meeting having been 50/50 for a rate cut this week. A month after the general election and on the eve of Brexit, it would seem a good time to take stock of how the UK economy is performing and therefore the context in which the MPC decision is being made.

  • Following the Conservative victory in the general election, there has been a bounce in sentiment in various parts of the UK economy. Data from the property company Rightmove suggests that UK house prices have risen 2.3% since the election, although it is worth noting this is a rise in the ask price not the transaction price. December car registrations rose 3.4% versus a 1.3% decline in November (Bloomberg data). Business optimism is on the rise; the graph below using data from the Confederation of British Industry shows a sharp rebound in manufacturing sector optimism.

Source: Confederation of British Industry, 31 December 2019

  • The UK government’s budget is due in March, and while the Chancellor of the Exchequer, Sajid Javid, is keeping his cards fairly close to his chest with respect to specific details, we believe the direction of policy is going to be clear – the manner of last month’s Conservative electoral victory suggests a strong policy focus on helping the regions and communities which feel ‘left behind’ in the post-industrial era.

  • Headlines such as those suggesting that the House of Lords potentially is moving to York or that the HS2 rail project is continuing despite sharp cost increases, even the rescue of the regional short-haul airline Flybe, all bely this change in focus to government policy which, whether Tory or Labour, has been accused over the past thirty years of working to the benefit of London and the south east to the detriment of the rest of the country. Boris Johnson has for now ruled out another vote on Scottish independence, and it seems that the various parties in Northern Ireland may be inching towards a deal to reopen the Stormont Parliament. At present, major constitutional changes in those parts of the union can be ruled out.

  • With a bounce in house prices, rising business optimism, and the promise of expansionary fiscal policy, why on earth is the Bank of England hinting that there may have to be a rate cut? The MPC is not prevaricating – there is clearly a concern that some of the economic data is still very weak as well as on-going worries that uncertainty over trade deal negotiations could prove to be a further source of disruption.

  • December’s UK manufacturing PMI data, although bouncing slightly, is still below 50 as the graph below reveals. The huge amount of global central bank easing in the second half of 2019 has led to a bounce in PMIs, but it is as yet unclear if this bounce will turn into a more sustainable rebound. Readings below 50 are contractionary for the economy.

Source: Bloomberg 27 January 2020

  • December’s CPI inflation reading also fell below estimates (1.3% actual vs 1.5% estimate, as per the graph below), and this may be where the real problem lies. Global markets rose in Q4 as Sino-US trade tensions dissipated and as central banks eased policy rates. While inflation expectations rose as a result, there is some evidence that they continue to remain subdued, or at least well below central bank targets (the Bank of England has a mandate to pursue price stability but this in practice means aiming at a 2% inflation target).

Source: Bloomberg 27 January 2020

  • When inflation expectations fall, central banks tend to cut rates to stimulate the economy. One of the by-products of this policy is that it tends to cheapen credit, allowing corporate (and government) debt balances to increase, adding to the aggregate cost of debt, reducing growth and inflation expectations, and thus forcing central banks to cut rates further in what appears to be a downward spiral.

  • The build-up of debt in the economy is starting to cause financial distress, even though this has yet to feed through to employment. In an article in the Financial Times, data from insolvency firm Begbies Traynor shows some 500,000 UK businesses now face distress in terms of falling credit scores or impending county court judgements for non-payment of debts (“Nearly 500,000 UK businesses face ‘significant’ distress”, Financial Times 27/01/2020).

  • The Q4 global reflation bounce has given way once again to falling rates and the spectre of debt-deflation. Having peaked at 0.87% on the day after the election, 10yr gilt yields have fallen to 0.52%, in part due to growing speculation that the MPC will cut rates. Falling rates have had a negative effect on the UK banks. Royal Bank of Scotland (RBS.LN) has seen its share price fall nearly 17% from its post- election day high of 265p (graph below). Strong banks are usually the sign of a strong and growing economy.

Source: Bloomberg 27 January 2020

  • The pound has been understandably unstable given the backdrop of rate uncertainty. Chancellor Javid has indicated that the UK will not necessarily be seeking close alignment with the EU in trade talks. The Brexit bill has been amended to ensure an outcome (as yet undecided) by December 2020, raising the prospect of a new cliff-edge. All of this adds to uncertainty. While US treasury secretary Mnuchin has spoken of a US-UK trade deal in 2020, issues over the use of Huawei technology in the UK’s 5G network may yet cause a diplomatic rift. Cable has fallen from its post-election high of $1.35 and is just about hanging on at the $1.30 level (graph below).

Source: Bloomberg 27 January 2020

  • Since the day after the general election, the pound has fallen, gilts have rallied, and banks stocks have fallen sharply. The Bank of England may or may not cut rates depending on the direction of the world economy in general and of EU trade negotiations in particular. The UK is about to embark on what is hopefully a new, exciting, and successful journey outside the European Union. Markets are however suggesting the first few steps may yet prove to be difficult, or at least uncertain.


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