Purgatory not hell

  • Written by 
  • 10/10/2016

“I always avoid prophesying beforehand because it is much better to prophesy after the event has already taken place.” Winston Churchill

A couple of months ago global capital markets retched as the UK electorate voted to leave the EU. Many foresaw not just a UK economic disaster, but a global slump, with the uncertainty generated by the UK referendum result forcing firms to pare back on hiring and investment across Europe in particular. So far, such fears have proved wide of the mark. Global capital markets continue to hum along, with US stock markets reaching new all-time highs and market volatility falling to multi-year lows (Figure 1). This quarter we look at whether such supine markets are in danger of underestimating the threats still lying ahead and what the economic data tell us about the UK economy’s reaction so far.

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With two whole months of post-EU referendum economic data in our rear-view mirror, we now at least have a plausible glimpse of how the economy has reacted to the EU referendum. To a certain extent, the tale told by this still short period is one of immediate shock from consumers and businesses, but also of rapidly returning composure amidst some settling of the political and economic dust (Figures 2 and 3).

What the data tell us

For consumers, there has so far been a sharp divergence between actions and words, with retail sales failing to support the gloomy prognosis for consumer spending indicated by the surveys (Figure 4). In line with the academic consensus, our research has shown that changes in consumer confidence normally reflect changes in the standard economic determinants of consumption such as labour market conditions and household wealth1. So far, these determinants have not deteriorated noticeably – a net positive for household consumption. In fact, in the month following the referendum the number of people claiming jobseeker’s allowance actually fell (Figure 5), UK large cap stocks entered a so-called ‘bull market’ while the housing market has so far held up well (Figure 6). That UK housing prices have continued to grow at their usual rate may come as a surprise, though a decline in housing supply has certainly been supportive2. For now, we can afford to remain reasonably relaxed about the fundamentals of the UK housing market – a sector which makes up a sizeable chunk of total output (Figure 7).

The UK’s much criticised current account deficit (Figure 8) has been another source of concern in the aftermath of the EU referendum, seen as making the country vulnerable to sudden stops in capital inflows should foreign investors lose confidence and decide to stop lending to the UK. However, there are simply very few economies around the world with comparable institutions and governance, as evidenced by the country’s lofty ranking in the World Bank’s Ease of doing business index. Such institutions alongside a long, rarely blemished track record in the sovereign bond market have so far decisively outweighed any preliminary uncertainty from the UK’s surprise vote. We would need to see a fairly dramatic dismantling of the above long-entrenched advantages for this to change in our view.

Rapid reaction

While investors quickly relaxed their stance on Brexit, the Bank of England (BoE) certainly didn’t. As the PMIs and consumer confidence began to deteriorate, the BoE decided to implement additional easing measures by cutting the Bank Rate, restarting its quantitative easing (QE) programme, and provisioning cheap funding to banks under a new Term Funding Scheme. That the BoE would act so decisively despite greater inflationary pressure from sterling depreciation (Figure 9), shows the BoE’s willingness to support growth at the potential cost of a transitory period of above-target inflation. Such a move is consistent with the BoE’s past decisions, as seen by a similar episode in 2013 where rates were kept near zero despite a transitory period of above-target inflation, also caused by sterling weakness. Despite an earlier gaffe where the BoE failed to find enough Gilt sellers for its restarted QE programme, overall the resumption of QE has helped UK Gilt yields fall to fresh all-time lows (Figure 10). This should, in theory, lower the cost of borrowing for households and businesses, and also trigger portfolio rebalancing into riskier assets, further enhancing the supply of credit to the broader economy.
 

How does the Term Funding Scheme work?

A traditional cut in the Bank Rate will lower borrowing costs for households and businesses, thus providing additional stimulus for spending and investment. However, as interest rates are currently close to zero, it is likely difficult for some banks and building societies to reduce deposit rates much further, which in turn might limit their ability to cut their lending rates. The BoE’s newly launched Term Funding Scheme (TFS) is designed to mitigate this, by providing funding for banks at interest rates close to the Bank Rate. Banks can initially borrow 5% of their stock of outstanding lending to UK companies and households, and banks that maintain or increase such lending will benefit from the lowest rate, equal to the Bank Rate. In addition to initial allowances, for every extra pound their net lending increases, banks will be able to access another pound of funding between the end of June 2016 and the end of December 2017. For each 1% fall in their net lending, the cost of funding on the scheme will rise by 5 basis points, up to a maximum of 25 basis points over the Bank Rate. This helps to ensure the Bank Rate cut is passed through to households and firms, thus reinforcing the transmission of lower rates to the real economy. In addition, the TFS provides participants with a cost-effective source of funding to support additional lending to the real economy, providing insurance against the risk that conditions tighten in bank funding markets.

“Overall, we retain our long-held view that the impact of an exit from the EU on the UK economy will be unhelpful but digestible”

Conclusion

Overall, we retain our long-held view that the impact of an exit from the EU on the UK economy will be unhelpful but digestible3. Admittedly, most of the questions posed by the EU referendum result remain unanswered, and will remain so for some time yet. For now, we can nonetheless take some reassurance from the political debate, where openness to trade seems to be still high on the agenda, much as we have suggested4.

The next few years will no doubt further bolster the idea that free lunches are rare in the geopolitical arena. In particular, those hoping for a bespoke ‘Swiss-style deal’ – where the UK financial sector gets to keep its access to the EU while obtaining sovereignty on immigration – are likely to end up being disappointed. Just ask the Swiss themselves, who have neither a financial services agreement with the EU, nor restrictions on the free movement of EU citizens across its borders despite negotiating for 10 years5.

Whatever the UK’s plight, it contributes less than 5% to the world’s output (Figure 11), a contribution that will continue to fall in coming years amidst ever greater contributions from faster growing emerging markets economies. The debate about the UK economy and its position in the world is therefore interesting to its residents and other concerned parties, but unlikely to be material to well-diversified investors. Here it is the global economic backdrop, where the forces of growth and inflation remain underestimated, that we expect to be most important for capital market returns over the next 6 – 12 months.

1 In Focus – Confidence tricks, 12 August 2016
UK house prices defy Brexit gloom, rise in August – Financial Times, 31 August 2016
In Focus – Brexhaustion, 29 January 2016
4 In Focus – Out, 24 June 2016
5 Swiss-style deal will not work after Brexit, Hildebrand warns – Financial Times, 4 September 2016