2019 Outlook

If you had to sum up why world, ex-US, financial markets typically underperformed during 2018 then economic growth, currency movements, and trade talk uncertainties would be the three most influential headwinds. Simply put, U.S. economic growth surprised on the upside whilst other major economies did not, the dollar appreciated against most other currencies, and concerns about essential future trading relations impacted the more export-focused European and emerging markets last year. In order for international markets to gain momentum over the U.S. in 2019, these concerns need to be quelled.

Decisions, decisions

I thought I would use Billy Connolly’s witticism about his homeland to highlight the essential debate in financial markets at the moment. During the last month, the UK’s most-quoted stock market index – helped by a rising oil price boosting energy sector shares – reached an all-time high.

Investment Strategy Quarterly

Outside of a few select emerging markets, inflation worries have been notable by their absence for financial market participants in recent years. Of the major global central banks, only the Bank of England is currently mildly embarrassed due to the specific influence of lapping the post Brexit referendum vote weak Pound period, which had a mechanical impact of raising import prices.

The UK is dancing all by itself

I pointed out in the most recent Investment Services Quarterly that over the past fifteen or twenty years October had a slightly rude reputation as a bad month for equity market investors. October 2017 will go down in the history books as not only being a positive month for almost all global investors, but additionally one which saw many well-regarded volatility measures continuing to bump along the bottom.

Investment Strategy Quarterly

What were you doing on the 5 July 2007? I cannot remember either, but the history books tell us that this was the last date when the Bank of England raised interest rates (by a quarter of a percentage to 5.75%). Since this point, interest rates have only fallen, including the most recent August 2016 decrease to the current rate of just 0.25%.

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Is the BOE on the Cusp of Tightening Policy?

What were you doing on the 5 July 2007? I cannot remember either, but the history books tell us that this was the last date when the Bank of England raised interest rates (by a quarter of a percentage to 5.75%). Since this point, interest rates have only fallen, including the most recent August 2016 decrease to the current rate of just 0.25%.

But is this about to change? Traditionally, independent Central Banks with relatively narrow inflation control mandates, like the Bank of England, typically raise interest rates when the level of price increases threatens to pierce their target inflation level. For the Bank of England this moment was, a number of months ago, influenced by the impact on imported prices, like energy, by the sharp fall of the Pound in the second half of last year.

Given the uncertainties around Brexit and recent economic growth data, which has been typically weaker than other developed market peers, this has caused a conundrum for the Bank of England. Reflecting this, the Bank’s own Monetary Policy Committee (MPC) observed a few weeks ago, after a meeting which concluded that interest rates should be currently held, that:

“The MPC’s remit specifies that, in such exceptional circumstances, the Committee must balance any trade-off between the speed at which it intends to return inflation sustainably to the target and the support that monetary policy provides to jobs and activity.”

‘Exceptional circumstances’ covers a variety of sins but maybe something has changed in the water at Threadneedle Street because Mark Carney, the Governor of the Bank of England, in an even more recent national radio interview said that ‘we can see that in the coming months if the economy continues on this track it may be appropriate to raise interest rates’.

Well that is a surprise – and certainly induced an immediate response from both the bond markets as well as mortgage lenders. So what is the reality and can we expect, for the first time in over a decade, an increase in interest rates?

The economic case for an interest rate increase is currently not wholly proven. Brexit negotiations are an uncertainty and the average consumer remains under pressure with limited wage increases and high personal debts. However, monetary policy remains exceptionally loose with a negligible 0.25% base interest rate, the Pound on a trade weighted basis near multi-decade lows and a quantitative easing stimulus programme, which was further augmented at the time of the last interest rate reduction in August 2016 when the big fear was an imminent shift of the UK economy into recession.

In short, a very mild tightening of policy – maybe reversing some of the extraordinary additional stimuli measures implemented fourteen months ago – is quite plausible and would reflect an acknowledgement that, whilst the backdrop is still uncertain on an absolute basis, relatively speaking there is slightly more clarity. However, the bigger insight is that anyone expecting a return to the interest rate or broader monetary policy norms of the generation before the global financial crisis a decade ago is going to be incorrect.

The Bank of England is not the only central bank coming to these conclusions. The Federal Reserve in the United States was the first major western central bank to slash interest rates and introduce a quantitative easing stimulus programme in the aftermath of the events in 2007 and 2008. As is often the case with economic policy, the ‘first in, first out’ rule is very apparent. Famously, the Federal Reserve raised interest rates after seven years of pause in December 2015, and since then there has been a further three small tweaks up. Perhaps more insightfully is that the pause on the creation of new central bank stimulus pre-dated any of these interest rate movements and occurred in October 2014 (and actual balance sheet size reduction is only starting this month).

The essential conclusion from all of this is that the speed of policy tightening is, by historical standards, desperately slow reflecting the ongoing challenges for most global economies. This broad profile is highly likely to be replicated by the Bank of England: potentially a minor tweak up in interest rates and a progressive end to new expansion of the quantitative easing balance sheet. If the Bank of England does decide to move in upcoming months, the magnitude of the shift will be extremely minor: there are too many fears out there to do anything else.

And this is why knowing what you are investing in and why is absolutely critical for the next few years, whether you are a bond or equity investor.

Chris Bailey, European Strategist, Raymond James Euro Equities