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Kristina Hooper | August 9, 2017

Market review: Between a rock and a hard place in the U.K.

Last week, the Bank of England (BoE) opted to keep its key short-term bank lending rate unchanged at 0.25% by a vote of 6-2. The BoE’s Monetary Policy Committee is keeping interest rates ultra low because of concerns that the United Kingdom (U.K.) economy is too weak to accommodate higher borrowing costs. It may seem surprising that the BoE is so concerned about the economy, given that the U.K. has very low unemployment; the current rate is 4.5% – the lowest rate in years.1 That may seem doubly surprising, given that inflation has been rising and could likely be nipped in the bud through higher rates.

Consider, though, that inflation is actually outpacing wage growth – creating a difficult scenario for consumers. Consumption is falling, business investment is slowing, and there is still some slack in the labour market, despite a low headline unemployment number. Moreover, there is the great uncertainty of Brexit and how that might affect the U.K. economy. Along with its decision to maintain rates at current levels, the BoE downgraded forecasts for economic growth. As of Aug. 2, economic growth for 2017 was revised down to 1.7% from 1.9%, and 2018 economic growth projections were revised down to 1.6% from 1.7%. However, the BoE upgraded its inflation expectations from 2.6% to 2.7% for the third quarter of 2017. And, so, the U.K. finds itself stuck with a 0.25% bank lending rate.

The pros and cons of accommodative monetary policy

The BoE’s decision underscores a growing quandary facing the central bank. The BoE’s primary tool to combat inflation and the pressure placed on consumers by lower real wages – raising rates – could also be the very instrument of a downturn in the U.K. economy. Moreover, the BoE has to worry about the impact that an impending Brexit will have on the U.K. economy.

Conventional economic wisdom suggests that globalization is generally positive for economies.

As the U.K. moves closer to a separation from the European Union, however, reality about what a separation – especially a hard Brexit – means for its economy is settling in. For example, now that the definite date for Brexit has been set – March 2019 – companies are reducing their business investment, and are also reportedly refusing to raise wages in advance of Brexit, despite rising inflation. As such, the BoE will want to keep monetary policy loose in order to be supportive and avoid an economic downturn.

However, the BoE also needs to assure that accommodative monetary policy doesn’t create market distortions. And, indeed, accommodative monetary policy can create a variety of market distortions. Easy money alters the risk and reward profiles for different asset classes. It also tends to make consumers less risk averse. After all, taking on debt is easier when interest rates are lower. And that’s what is happening in the U.K., where consumer credit has grown significantly.

Concerns about U.K. consumer debt lead to downgrades

In fact, consumer credit has grown so much that recently Moody’s waved some red flags, downgrading its outlook on most U.K. consumer debt. In downgrading its ratings on auto asset-backed securities, credit card asset-backed securities, as well as some mortgage-backed securities, Moody’s expressed concern that “household indebtedness is already very high by historical standards.”2

In my view, the Moody’s decision seems appropriate, especially given that consumer credit growth has significantly outpaced household income growth in the U.K. In addition, U.K. household savings is on the decline. A substantial dip in personal savings is viewed as a possible warning sign of recession since, historically, such drops have preceded some recessions. If nothing else, a low savings rate means that consumers are more vulnerable to a downturn in the economy. Consumers are even more vulnerable if their debt is variable and rates begin to rise. In its analysis, Moody’s explained, “Under the Brexit negotiations, our base case remains that the two sides will come to an agreement that captures many – but not all – of the current trade arrangements.”2

I am concerned that Moody’s may be too optimistic in its base-case scenario, given Prime Minister Theresa May’s seemingly uncompromising pursuit of a “hard Brexit.” Moody’s at least recognizes that there is the potential for disruption caused by uncertainty during negotiations, as well as the potential for significant disruption if the base case is not realized, explaining, “… there is the added uncertainty in the run-up to the final exit and the substantial probability that negotiations will fail and no agreement will be reached. Macroeconomic disruption from a ‘no deal’ could be significant.”2

In short, it seems that the BoE opted for the better of two unattractive options in choosing to maintain the current bank lending rate. The inflation shock from a weaker sterling may be a shorter-term price shock rather than an inflationary process that could filter through wages and prices generally. With uncertainty around Brexit so significant, I believe the better path was to be supportive of the economy.

U.S. facing some of the same dilemmas

In some ways, the U.S. can look to the U.K. as a cautionary tale. While the U.S. has relatively low inflation that the Federal Reserve (Fed) would like to see rise, it is facing some of the same issues as the U.K. – specifically, geopolitical uncertainty brought on by de-globalization policies and greater consumer vulnerability. Recall that last November’s presidential election was arguably a referendum on globalization – both trade and immigration – so it was not that different from the Brexit vote. While small in comparison to what the U.K. might see, I believe the U.S. needs to be vigilant about what any de-globalization measures might mean for its economy going forward. After all, we can’t forget the negative impact that protectionist measures had on the U.S. economy in the 1930s. And we can’t ignore that, historically, companies have reduced business investment in the face of economic policy uncertainty.

Possible consumer vulnerability

The U.S. bears a resemblance to the U.K. in that it’s seeing a falling personal savings rate. In fact, the monthly personal savings rate in the U.S. dropped significantly late in 2016 to well below 4%. For most of 2017, the rate has also been below 4%. The last time the personal savings rate as a percentage of disposable income was below 4% was in advance of the Great Recession.1 As in the U.K., there are also concerns about some forms of U.S. consumer debt, particularly auto loans.

Unemployment remains low in the U.K., U.S.

The U.S. also bears some similarities to the U.K. in its low unemployment rate. The Bureau of Labor Statistics’ Employment Situation Summary for July showed an economy that continues to create jobs at a fast clip, despite the length of the labour market’s recovery. The U.S. added more than 200,000 jobs in July, and the unemployment rate fell to 4.3%. Even wage growth was solid, although there is clearly some slack in the labour market. And, as mentioned above, unlike the U.K., inflation has remained low, which means real wage growth is far more attractive than in the U.K.

As such, the Fed may face a different quandary from the BoE. Can it continue to tighten, given that inflation is below its target rate? And can it continue to tighten, given policy uncertainty around tax reform, the potential for a debt-ceiling crisis and even the potential for a government shutdown this fall?

Looking ahead, it will be important to follow political and monetary policy developments in both countries, as they have the potential to significantly affect their respective economies. Of course, the similarities and differences between the U.K. and U.S. economies remind us of the importance of diversification for both equity and fixed income sleeves of investors’ portfolios.

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1 Source: FactSet Research Systems Inc., as at Aug. 4, 2017

2 Source: Moody’s Investors Service, as at July 31, 2017

Diversification does not guarantee a profit or eliminate the risk of loss.

All investing involves risk, including risk of loss.

The opinions referenced above are those of Kristina Hooper as of August 7, 2017. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.

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