The major event of the last month was the decision by the Bank of England Monetary Policy Committee (MPC) to cut the base rate for the first time since 2009. Seven years ago, when rates were last cut, it was seen as a temporary move to support the economy after the financial crisis. Since then markets considered the possibility of a move back up in policy rates but the MPC lacked the confidence to do so. The recent move was a direct response to the Brexit vote.
The quarter point rate cut was accompanied by additional Quantitative Easing (QE) in the form of a further £60 billion of gilt purchases and up to £10 billion of corporate bond purchases. To ensure the rate cut can be passed on to banks’ customers the MPC introduced a Term Funding Scheme (TFS). They expect this facility may grow as much as £100 billion. While the rate cut was widely expected, the additional QE and TFS were more than anticipated.
Some commentators have suggested that this move was an over the top reaction to the referendum result. In July, many people expected the MPC to cut rates but they held back. We expected them to wait for their Quarterly Inflation Report which contained economic forecasts post Brexit. Incremental data points towards delayed investment decisions as a result of the broad uncertainty. The MPC is attempting to boost confidence by acting decisively now. They reiterated their willingness to act should economic conditions deteriorate but recognise the adverse effects that negative interest rates can cause.
At the press conference following the MPC meeting, the Governor was asked how he felt about savers considering the low level of interest rates. He was sympathetic but commented that broader economic stability takes precedence. If the Bank of England (BoE) prediction of inflation at 2.4% in 2018 is correct, then deposits earning next to nothing will give investors negative real returns. This may encourage spending or investment into riskier asset classes including equities.
Clearly the developments in the UK market will be dominated by the Brexit negotiations. However elsewhere in the world, better employment statistics in the United States make the next rate rise a possibility before year end. Economic data out of Europe continues to fail to suggest the need for more support from the central bank. Italian banks are a particular problem but EU regulations make it difficult for the government to support them. The Italian Government has a referendum on constitutional reform in October which they need to win despite rising opposition from the anti-euro Five Star Movement.
For the remainder of the year we expect equity markets to find support from low yields. The cheap cost of funding is likely to support further mergers and acquisitions in equity markets. However, considering the differing outlooks across sectors and geographies, dispersion of returns are likely to increase further. As equity markets head higher and bond yields fall further, they become riskier and we may have to accept higher volatility. In the UK, Brexit negotiations will dominate our discussions for months to come and we will be monitoring any developments closely.