Following on from June’s referendum, we published a brief piece offering our impartial observations on the result and provided forecasts regarding various events which, in our view, were likely to unfold in the aftermath of the vote to leave the EU. As we do not consider ourselves to be financial market prognosticators, we will very modestly mention that two of these forecasts proved particularly prescient.
The first being that markets tend to overreact in the short term following the onset of negative and/or unforeseen events. On this note, following an initial period of weakness in UK and global equity markets, both have rallied strongly from their respective referendum lows. For example, both the FTSE 100 (GBP) and the broader MSCI World Index (USD) are up circa 12.5% from their June troughs at the time of writing.
A second observation was in relation to the Bank of England’s (BoE) supportive wording following the vote. Governor Carney stated on 24th June: ‘The Bank will not hesitate to take additional measures as required as markets adjust and the UK economy moves forward.’ In this note we attempt to provide some clarity regarding the actions taken by the BoE and as well to highlight their intended consequences.
Monetary vs. Fiscal Policy
We thought it may be useful to provide our clients and readers with a very brief comparison of the key tenets of monetary vs. fiscal policy – with the BoE holding responsibility for the former. These are set out below:
Last week’s actions by the Bank of England relate to two key areas listed above pertaining to monetary policy: interest rates and money supply. We discuss these in further detail below.
The first measure announced by the BoE was the reduction of the base rate to a historic low of 0.25%. This marks a decrease from the previous level of 0.50% which, prior to this most recent cut, was the lowest rate ever set by the Bank since its founding in 1694. The lowering (or raising) of interest rates is the most conventional/traditional tool used by central banks when attempting to either stimulate or moderate their respective economies. The most direct intended outcome of a change in interest rates is to shift consumers’ propensity to save versus their propensity to consume. By creating a low interest rate environment, the desired outcome by central banks is that a decrease in the propensity to save will translate to an increase in consumption which, in turn, should provide a boost to the economy. This most recent rate cut was considered somewhat of a foregone conclusion by many market participants given the foreshadowing offered by senior members of the BoE’s Monetary Policy Committee in recent weeks. To the casual observer, a reduction of this magnitude may perhaps appear immaterial in absolute terms; however, the accompanying language and the various less-traditional policy measures which were also announced combine to form a package which is both dynamic and material in nature.
The second step taken by the BoE in an attempt to stimulate the domestic UK economy comes in the form of a fresh round of quantitative easing (QE). The Bank announced that it will embark upon an asset purchase scheme which will include £60bn of UK government bonds and £10bn of qualifying UK corporate bonds. Compared to adjustments to a central bank’s base rate, QE is considered a non-conventional monetary policy measure; however, since the Global Financial Crisis of 2008, it has become a relatively common policy response with the central banks of the UK, EU and Japan all now engaging in QE in various guises. The US Federal Reserve is not currently engaged in QE, having previously terminated their programme which ran between November 2008 and October 2014.
What is Quantitative Easing and what are the intended consequences?
In very simple terms, Quantitative Easing involves the creation of new money by a nation’s central bank which is then used to purchase financial assets from banks. These financial assets typically consist of government bonds, though other assets such as corporate bonds and in some cases even equities may also be purchased. QE is designed to increase a nation’s money supply and to subsequently inject cash on to bank balance sheets which, in turn, should promote lending to consumers and businesses. In theory, this additional money in the economy should lead to an increase in consumption of goods and services, which should then provide a boost to disposable income and eventually job creation within an economy. It should be noted that QE is often implemented only when a central bank’s base rate has already been reduced to a perceived lower-bound, and further base rate reductions are no longer deemed feasible.
A second intended outcome of QE is to lower benchmark interest rates on cash and government bonds (‘risk free’ assets) which in turn should encourage a flow of capital into riskier and higher yielding assets such as corporate bonds, property and equities. For example, by purchasing large quantities of government bonds, central banks drive the price of these bonds up and as a result drive the yield / expected return on these assets lower. On a relative basis, this makes higher yielding assets such as corporate securities more attractive, sparking increased investor demand for them and reducing the return (yield) investors require to hold them. Speaking again on a theoretical basis, this increased demand should provide businesses with financial capital which those firms can then deploy into economically-accretive projects. The chart below provides a basic illustration of this effect across the risk spectrum of various financial assets. We would like to remind readers that an asset’s yield is inversely-related to its price; as the yield decreases, the price will increase, though not always in a purely linear fashion.
The discerning reader may very well think that this is a process which is easier said than done; a statement with which we would concur wholeheartedly. Lowering interest rates and providing banks with fresh cash/liquidity does not equate to the instantaneous provision of additional loans to consumers. Indeed, when the BoE embarked upon its first QE programme in the wake of the Global Financial Crisis, an adverse scenario known as a ‘Liquidity Trap’ unfolded. Fragile banks were reluctant to lend to consumers for fear of heightened loan defaults, and consumers were simultaneously apprehensive when it came to taking on more debt given the uncertainty surrounding the economy. In other words, there was a blockage in the transmission mechanism between the central bank’s injection of newly created money, and that money finding its way to the end-consumer. Secondly, low interest rates can be detrimental to bank earnings. As demand for deposits (the propensity to save) tends to decrease, so too does the amount of money banks have on hand to loan; furthermore, the rates of interest banks are able to charge on loans tend to fall, which negatively impacts a key source of bank revenue known as interest margin.
Aware of the detrimental effects that near-zero interest rates can have on banks, the BoE announced an additional measure to compliment the overall stimulus package which they have titled the ‘Term Funding Scheme’. Governor Carney outlined the plan which will see up to £100bn of cash lent to banks at close to the base rate (0.25%) to finance new loans made by banks to consumers and businesses – so long as certain requirements are met. Dynamic and creative in nature, the Term Funding Scheme will hopefully serve to both mitigate the deleterious effect of low interest rates on bank profitability, whilst also helping to ensure that the new stimulus measures see their way through to the end consumer. In an amusingly-marked departure from typical central banker parlance – which is often decidedly soft, vague and indirect – Governor Carney sent a shot across the bow of UK lenders by stating: ‘Banks have no excuse with today’s announcement not to pass on this cut in rates and they should write to their customers and make that point’. Such forthright language by the head of a central bank is rare and it would seem to reinforce the BoE’s resolve to ensure that these new measures are quickly and efficiently transmitted to UK households and businesses.
As ever at Aspinalls, we encourage our clients to invest for the longer term. Events such as the referendum outcome and the recent change to the Bank of England’s monetary policy are of course significant and noteworthy; however, financial markets are constantly challenged by various causes and effects and the longer one can remain invested, the greater the probability of earning positive returns over and above that of inflation.
If you would like to discuss any points raised in this report or any aspect of our investment services please do not hesitate to contact our offices.
The official Bank of England press release summarising the measures taken and the associated rationale can be found here: https://www.bankofengland.co.uk/publications/Pages/news/2016/008.aspx