In the post-Brexit political turmoil that has engulfed the UK, the Bank of England is providing some required adult supervision. It’s early diagnosis of the economic impact of the Brexit vote allied to it’s policy response – talk of monetary easing, and the Financial Policy Committee’s easing of financial conditions via the regulatory channel – are necessary and welcome. However, a theme of the post-crisis global economy is that monetary policy should not bear the brunt of reflationary policies due to diminished money multipliers. Fiscal policy needs to be more active. Unfortunately, the government’s talk of corporate tax cuts will do little to address the looming problem of insufficient aggregate demand and of the risk that UK consumers copy their US counter-parts and increase their savings rates. A policy response that is uncoordinated across reflationary levers implies continued downside for the GBP, which we expect to depreciate to below 1.20 vs. the USD. Meanwhile GBP interest rate markets have continued reason for strength. We continue to see the 10yr Gilt yield moving flat to a lowered (0.25%) policy rate, and over the coming months see receiving the GBP IRS 10fwd 10yr becoming a higher beta play on the GBP yield curve.
“Exit, pursued by a bear”
The end of a campaign that focussed on the visceral rather than the cerebral has failed to usher in a more edifying period in British politics. The Conservative party is engulfed with its leadership campaign and internecine warfare among the leaders of the Leave campaign, played out against an economic and financial market backdrop that sounds eerily akin to what the “experts” warned about. (The Shakespearean stage direction “exit, pursued by a bear” sounds appropriate as key Leave campaigners fail in their political ambitions). The Labour party is in a battle to avoid itself becoming a marginal voice in the national debate, especially as the departure of Nigel Farage can accelerate the rebranding of UKIP into a party more able to sustainably secure the support of working class voters. Meanwhile, the closest the “Leave” campaign has come to providing a plan for the new reality was a Boris Johnson comment that combined with a “don’t worry, be happy” message along with a plaintive cry that “someone should be coming up with a plan”.
Chart 1. The policy vacuum lends support to GBP interest rate markets
Adult supervision to help prevent the affect heuristic
The Bank of England is the institution that has come closest to providing the adult supervision that the UK so urgently requires. Last week’s speech by Governor Carney outlined in reasoned terms the transmission mechanism of the shock of Brexit to the real economy, noting that the event was causing a form of economic Post traumatic Stress Disorder. He also noted something that has been a key feature of our analysis – how an economic shock can lead to a sustained, long-term change in consumer, corporate and investor behaviour, a process he terms an “affect heuristic”. This is a critical observation as such an effect heuristic is evident in the changed behaviour of individuals in much of the developed world following the financial crisis, and which has seen a diminished pricing power of labour, a greater aversion to leaving payed employment (reduced job churn) and – most clearly in the US – a structurally higher household savings rate. (The Income-lite recovery trend.) Even before the Brexit shock, the effect heuristic was a key feature in our view that wage growth in the UK (and much of the developed world) will disappoint despite optically tight labour markets in many countries, and reinforce the downside risks to price stability. In the UK, Brexit has reinforced this trend, and may also undermine one area where the UK economic recovery has differed from that of the US – the greater propensity of UK households to increase their leverage and lowering their savings ratio. (Chart 2.) If UK households become more cautious, a key driver of UK economic growth will be restrained.
Chart 2. UK households have lowered their savings ratios in recent years, in contrast to US households
Monetary easing ahead
Having outlined the channels of causation from Brexit to real economic weakness, Carney was quick to note the need for policy stimulus. He spoke of the likelihood of monetary easing over the summer. The most obvious initial step would be to lower the 0.5% Bank rate to 0.25%, and with the Gilt yield curve below the current policy rate up to 6 years, the market clearly expects such an easing. Beyond that, our expectation is that QE will be re-launched, with the increased Gilt purchases hoping to push liquidity closer to the point of a private sector economic transaction via the portfolio effect. A policy rate cut at the forthcoming 14th July BOE MPC meeting would be optimal as it would reinforce the sense of the Bank being swift to respond to economic risks, but there may be a preference to wait until the 4th August meeting when the inflation report will also be released.
Gilts to become more collateral than yield products
These two policy responses, coupled with an expected UK slide into recession over the coming 12 months, underpin our forecast that the 10yr Gilt yield will trade flat to a 0.25% policy rate, and in the process Gilts will adopt more of the characteristics of Bunds, whereby they become viewed more as collateral that yield instruments. (This transition to being a collateral instrument actually happened to Bunds over 3 years ago, a fact that the widespread wailings against the bubble implicit in a negatively yielding Bund curve tended to overlook). (Brexit – an unchartered path to Tartarus?)
Keeping the credit channel open – delaying the counter-cyclical capital buffer increase
Equally welcome, was the Bank’s keen awareness of how it needed to prevent the effect of looser monetary policy being offset by tighter monetary conditions by financial institutions becoming more risk averse to balance sheet usage. The prospect of a recession and rising levels of non-performing loans and increasing credit risk would naturally make financial institutions in the UK more wary, and the post-Brexit slump the share price of banks would compound this risk. While the UK banking sector is well capitalised, with an aggregate Tier 1 capital buffer of 13.5% among the major banks, the experience of the financial crisis revealed that the highly leveraged nature of bank balance sheets meant that capital buffers can swiftly be eroded. Reduced balance sheet is a natural first response to potential pressure on capital buffers. Aware of this risk, the Banks’s Financial Policy Committee (FPC) decided to delay it’s planned increase in the counter-cyclical capital buffer that UK banks were requited to implement by 29th March 2017: this was due to rise from 0% currently to 0.5%, as part of a medium-term path to 1%. (The FPC estimates that the associated GBP5.7bn reduction in required capital could support GBP150bn in credit to the real economy). Removing this target was wise as it reduced the risks of banks focussing on preservation of their capital base, which could have further lowered money multipliers and required more offsetting monetary easing. To reinforce this point, the Bank has committed to providing sufficient levels of liquidity to the banking system, to prevent any liquidity concerns emerging and has also allowed insurers greater flexibility over the application of Solvency II, to prevent a pro-cyclical selling of credit products.
Cure or a palliative?
These are all positive developments. However, they are more likely policies that will help slow the deceleration of the UK economy rather than notably change the country’s short-term economic trajectory. As we have noted at length, one of the key reasons why the global economy has failed to overcome its slow burning growth crisis is that macro-economic policies are un-coordinated across geographies and reflationary levers. On the latter point, monetary policy has been the only game in town for most developed economies, which has limited effectiveness since insufficient aggregate demand is limiting the appetite for economic agents to borrow at low lending rates to finance investment. Weak money multipliers are forcing more central banks to go down the path of unorthodox policy easing, which in some cases results in negative interest rates and in others ever-expanding QE policies. One of our core fears for global markets is that we reach a level where monetary policy is believed to have reached its practical and political limitations and where growth remains laggardly. There is a compelling need to combine loose monetary policy with a fiscal policy that can help inject demand into the UK economy. (Avoiding the Brig Crunch – Policies to prevent a deflationary world.)
Chart 3. The UK government is unlikely to allow a marked reversal of it’s austerity focus
The UK fiscal response – welcome but misguided focus
On the issue of the fiscal response, there is less reason for cheer. To start with the positive, Chancellor Osborne has given-up the ghost of his targets of a budget surplus by 2020, a policy which would have required notable pro-cyclical fiscal tightening into an economic downturn. However, he remains very far from making a decision to implement a fiscal stimulus to buttress aggregate demand during the coming economic downturn. While we would favour a fiscal stimulus of 1-2% of GDP for the next few years – an increase in public borrowing that would not increase Gilt yields given that the UK will have an enlarged zero bound problem in terms of the BoE’s policy rate – Osborne has instead raised the idea of a 5pp cut in corporate tax rate to 15%. There are welcome aspects to the proposed tax cut, as a lower tax rate could reduce the extent to which some firms delaye/ postpone investment decisions and curtail production as they would have a higher potential return on capital. It could also help limit the impact of Brexit on lowering FDI into the UK, which many overseas companies use as a platform for exporting to Europe. However, a tax cut would have a lower fiscal multiplier effect than increased spending since corporates would remain cautious with respect to the prevailing outlook for demand. After all, UK investment/ GDP is already extremely low post-crisis, as it is in many developed economies. (Chart 4.)
Chart 4. Corporate investment/GDP has fallen post crisis across developed economies
Consumer demand needs fiscal support
There is also the need to prevent consumers from reining in their horns and notably increasing their savings ratios. This is particularly true, since the household sector is likely to take the brunt of the economic impact following the Brexit vote if recession does indeed strike, which will push up unemployment and lower already mediocre wage and income growth. Moreover, there is a medium-term risk that Brexit will exacerbate many of the problems that are currently limiting the pricing power of labour. Many companies invest in the UK, for access to the European market and to benefit from the UK’s flexible labour markets. If access to Europe becomes less certain, there is a natural risk that policy-makers compensate with increased labour market flexibility. The fiscal stimulus package should implement policies that could help support UK household incomes and consumer confidence. An ideal policy would be a consumption voucher that contained a time limit: the voucher had to be consumed by a certain time period or it expired.
A sub-par policy response
The insufficient policy response to the shock of Brexit, continues to influence our views on the market impact. The over-reliance on a monetary policy response, with the low multiplier effect implicit in this policy path, adds to the downside risk to GBP. We expect GBP/USD to decline below 1.20 over the coming months, with downside beyond this level contingent on the scale of the ensuing economic weakness in the UK. At 6.9% of GDP at Q1-2016, the UK current account highlights the vulnerability of GBP to reduced capital inflows/ outflow of the stock of foreign investments. Although, as we showed in a recent note, one encouraging development is that Gilt yields should be immune from even an accelerated pace of net capital outflows from the UK. (Gilts, the GBP, Brexit and the grudging longs.)
Chart 5. The 20-30-year part of the GBP curve should emerge as higher-beta ways to position for lower yeilds
Receive the GBP IRS 10fwd 10yr
Meanwhile, interest rate markets have further to rally. As we noted, 10yr Gilts are targeted at 25bp, and as the curve compresses over the coming weeks the higher beta trade is likely, to be further out along the curve. We particularly like receiving the GBP IRS 10fwd 10yr, which currently measures 1.43% and which should decline to below 1.0%. Chart 5. (This is a trade out of the JGB playbook, as the yield curve compresses across its maturity profile with the “sweet spot” for received/ long positions changing over time.) Meanwhile, a coming economic downturn, pervading and enduring political risk (even if the Conservative party coalesces around a clear leader, there will be string calls for a new general election while the spectre of a new Scottish referendum will begin to loom) and insufficient policy response does not make a conducive backdrop for the performance of risk assets such as equities or credit products over the coming months, despite a more accommodative monetary policy..