Though it may seem hard to believe, attention on policy makers has intensified. The market has delivered a vote of no confidence in the notion of negative interest rates and appears increasingly dissatisfied with the ability of monetary policy and QE to impact the real economy. There is also increasing appetite for something new, at least in the rhetoric of the IMF and G20, and in the actions of Canada and South Korea.
In this context, yesterday’s moves by the Bank of England could be important. Will they be interpreted as more of the same, or form part of a transition to policies that markets truly believe can impact the real economy? We don’t believe that forecasting policy action is something many investors can consistently make money out of, but understanding the policy regime is essential to any assessment of asset values.
UK policy action: was it necessary?
Yesterday’s measures could be seen as a necessary response to a significant threat to UK growth. The recent publication of a decline in the purchasing managers survey prompted a comment on Bloomberg TV that “we are in serious trouble,” while a UK think-tank called for a “sledgehammer” response to economic weakness. Growth expectations have collapsed.
However, as our colleagues at Bond Vigilantes pointed out earlier this week there is no small risk that policy action may be premature. Leading up to the Brexit date, data had been OK: unemployment is at a low level, real wage growth has been strong and consumer demand is booming. It could be that policy makers are overweighting their ability to forecast the impact of Brexit at the expense of ignoring what we already know about the state of the economy today.
We’ll never truly know the answer to these questions because we can never know how else history could have played out. However, perhaps the main worry is that too much is being expected of monetary policy.
UK policy action: does it even matter?
In 1968 Milton Friedman delivered a speech which in many ways seems more applicable today than when it was written. In it he said:
“…I believe that the potentiality of monetary policy in offsetting other major forces for instability is far more limited than is commonly believed”
Milton Friedman, 1968.
This argument is part of the reason why we generally believe that too much emphasis is placed on policy by financial markets, and why this creates opportunity for those willing to look through it. How much can we really expect from a 25bps change in interest rates to impact the earnings of FTSE 100 companies? This seems especially true when rates are already so low.
It is not a new argument that cutting interest rates appears to have become less and less effective in boosting growth. Eric wrote last year how low rates may actually be having the opposite effect to that intended. Mark Carney stated in yesterday’s press conference that he is “not a fan” of negative rates and the tone of conference suggested an acknowledgement that different policies were needed.
In this regard the cut in base rates and the new QE programme may be a sideshow, while the new Term Funding Scheme (TFS) could be extremely important. TFS represents an explicit attempt to ensure that policy actions translate to real effects on households and companies.
The question for investors is whether this change in mood will translate into a change in behaviour.
It remains to be seen whether ensuring that lower rates are transmitted more effectively will actually result in borrowing for productive purposes, or if it is simply the case that it is lack of demand for credit which is the issue. Perhaps more important is whether the UK government is about to act where the Bank of England cannot, on spending on its own projects to boost activity in the UK economy.
The notion of government spending has become a charged ideological issue. However, there is growing support that it is a tool that should be considered. It is possible for the government to spend without worsening the debt burden undoubtedly faced in many Western nations, if the spending will ultimately boost long term growth.
This is an argument gaining traction around the world. In June McKinsey issued a paper which reasserted their view that many nations could, and should, spend more on infrastructure to support growth. Both Clinton and Trump have discussed greater infrastructure spending should they become president. In the UK, the rhetoric of the new Prime Minister and Chancellor has been interpreted as suggesting a loosening of austerity.
On the surface this seems like a no brainer. McKinsey suggest that infrastructure spending has declined as a percentage of GDP in 11 of the G20 countries since the crisis, and this is borne out by OECD data.
This is at a time where some of the nations that McKinsey suggests need extra spending are able to borrow at all time low, and even negative, rates.
It may seem counterintuitive therefore that policy makers are employing ever lower rates to make the private sector spend, when even negative rates have not enticed extra spending on the part of governments.
If decision makers are moving towards a different approach to stimulating growth, it could represent a sea-change in the policy environment we have been living in for the last ten years. This could in turn result in a change to which investment strategies are successful and which fail.
Until now, policy makers have responded to weak growth with ever lower rates or further bond buying. This course of action has contributed to the strong performance of bonds, or bond-like assets – and has influenced investor perceptions of their ‘safe-haven’ qualities. A shift in the policy backdrop at this juncture could alter investor sentiment towards these types of assets. If strong growth were to emerge, for whatever reason, those assets and strategies which have struggled in the current environment, such as value, could begin to reassert themselves.