Investment Newsletter November 2015
Should the Bank of England put up interest rates? Mike Deverell Investment Manager
That’s the question that the Monetary Policy Committee (MPC) has to face at each meeting and it’s a decision that Bank Governor, Mark Carney, said would come into sharp focus around the turn of the year.
The Bank’s primary aim is to get as close to 2% inflation as possible. If the Consumer Price Index (CPI) is more than 1% higher or lower than the target, then Mr Carney has to write a letter to the Chancellor to explain why.
Last week the Bank released its quarterly inflation report, and this neatly illustrates the quandary that policymakers face. The Bank of England is tasked by the government to fulfil the following objective:
Historically, it was thought that price stability would mean economic stability, and as a result the inflation target has always been seen as the primary objective. More recently, the second part “to support the Government’s economic objectives” has become more important, particularly as inflation has deviated wildly from target.
“To deliver price stability and, subject to that, to support the Government’s economic objectives including those for growth and employment. Price stability is defined by the Government’s inflation target of 2%. The remit recognises the role of price stability in achieving economic stability more generally, and in providing the right conditions for sustainable growth in output and employment.”
Interest rates have been at 0.5% since 2009. From 2010 until the end of 2013, inflation was generally above target and was even above 3% for an extended period. The normal response to rising inflation is to increase rates as this is usually associated with an overheating economy. This clearly was not the case back then and so the Bank rightly did not put rates up because of economic factors.
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Investment Newsletter November 2015
Currently, CPI inflation is MINUS 0.1% pa so we are seeing mild deflation. It has been below target every month since the start of 2014. A typical policy response might normally be to CUT rates, or carry out other stimulus like quantitative easing, to try to generate some inflation. However, right now we are seeing a much better economic environment in the UK. In the inflation report, the Bank predicted relatively stable growth of between 2% and 3% pa over the next few years. We are also seeing relatively low unemployment, albeit with the caveat that there are many unknowns in the data. For example, we don’t know how many part-time employees want to go full-time, or how many of the record number of self-employed would actually prefer an employed position.
They think there is a 60% chance CPI will be within the mid blue area, so between around 3% and 1% inflation by 2018. The chart also implies a 90% chance it will be in the light blue areas – between around 0% and 5% inflation. There is also a 10% possibility it could be anywhere outside this range! Clearly there’s quite a wide scope for error but, in essence, if making a decision purely on inflation, rates would not be increased; but if making a decision just on the economy, they probably would. Chart 1 - CPI inflation projection
With growth and employment where they are now, we would normally expect rates to go up, but the prospect of inflation being back to target any time soon is seen as low. Chart 1 shows the Bank’s own predictions for CPI inflation: The dark blue area is the Bank’s central case; they think there is a 30% probability that inflation will be in this area. If they are right, this shows CPI not getting back to the 2% target until perhaps 2018.
What impact would a rate increase have?
One obvious concern the Bank will have is whether putting up rates will have a serious impact on household disposable income, and therefore spending. Household debt is below its 2008 peak but still remains elevated and is above many other developed nations: Chart 2 - Total household debt as a percentage of disposable income
Source: Bank of England Inflation Report November 2015
With interest rates so low this debt has been manageable to date but what is important is what happens if rates go back up. Luckily, the Office for National Statistics (ONS) collects all sorts of useful data, including how much households typically spend on their mortgages, both on capital repayments and on interest.
Source: Bank of England Financial Stability Report July 2015
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Investment Newsletter November 2015
Table 1 below shows the latest figures available from the ONS and our calculations of what might happen to the numbers if we adjust the interest payments figure. Table 1
For this we have assumed that everyone’s interest payments go up by 1.5 times – so if your interest payments are currently £100 they go up to £150:
Quintile group of ALL households Bottom
2nd
3rd
£11,662
£19,698
£26,686
Mortgage repayments for mortgage holders
£3,848
£4,773
£5,388
£6,557
£10,405
£7,555
Of which interest payments
£2,137
£2,189
£2,460
£3,052
£4,898
£3,541
Post mortgage payment disposable income
£7,814
£14,925
£21,298
£30,271
£53,649 £24,230
Repayments as % of disposable income
33.0%
24.2%
20.2%
17.8%
16.2%
23.8%
Mortgage interest payments
£3,206
£3,284
£3,690
£4,578
£7,347
£5,312
Post mortgage payment disposable income new
£6,745
£13,830
£20,068
£28,745
£51,200 £22,459
Change
-£1,069
-£1,095
-£1,230
-£1,526
-£2,449
-£1,771
Repayments as % of disposable income
42.2%
29.8%
24.8%
21.9%
20.1%
29.3%
Disposable income
4th
Top
£36,828 £64,054
All £31,785
Latest ONS Figures
If everyone’s interest payments went up by 1.5x
If we see this level of rate increase then, on average, a person’s mortgage repayments would go up by £1,771 per year, increasing from 23.8% to 29.3% of disposable income. Of course there are many different types of mortgage. A typical variable rate mortgage at present is around 2%, 1.5% above base rate. Essentially our calculations assume that base rates increase by 1% and this mortgage tracks the increase and goes to 3% pa. Some older mortgages track base rate more closely and so a rate rise would have a bigger effect, whilst fixed rate mortgages would see no effect until the end of the fixed
Across the pond...
In the USA things are slightly different. Firstly, the Federal Reserve has a specific dual mandate to target employment as well as inflation. Last week the latest employment figures showed significantly more new jobs being created than we expected. The bond market is now pricing in a December rate increase in the US. If you believe such things, traders are ascribing a 74% probability of it happening! Mind you something similar was said about September… That is one reason we’ve seen more volatility in the stockmarket again over the past few days, particularly in the States. Uncertainty breeds volatility and until
period. However, this gives a reasonable feel of the impact of a rate increase. As is so often the case, the impact is greater for those with the least, with the bottom quintile seeing their repayments as a percentage of disposable income go up from 33% to over 42% in this scenario. That’s quite a burden and illustrates just why the Bank will be very cautious about increasing rates. We are quite reliant on consumer spending for our economic growth and the MPC will be mindful of this when making their decisions.
the Fed actually makes the decision we could see more ups and downs. Whilst the case for a rate increase in the UK is unclear at present, in the US it would probably be best if they just got on with it and ended the guessing games. They could then wait around 6 months to assess the impact before carrying out any further increases However, if the Fed does put rates up, then that might increase the pressure on the Bank of England to do the same. Historically, where the Fed leads, the Bank of England tends to follow, usually around 6 months later. We would not bet against the same happening this time.
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Market Views November 2015
General Economic Overview The picture remains mixed in the global economy, with the UK and US remaining the leaders. Growth in emerging markets remains weak, although the picture looks slightly less bad than many had feared. However, commodity prices remain weak and this is one reason inflation is now marginally negative in the UK. Inflation will probably remain very low for some time and any interest rate increase in the UK seems unlikely until midway through 2016. Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class
Score
Equity Markets We keep our score the same as last month at -1. Many markets have rallied but the FTSE 100 in the UK remains one of the weakest markets. We have more exposure than usual to Japan and smaller companies in the UK which remain our preferred equity sectors.
-1
Fixed Interest Our score remains the same as last month at -1, which is substantially less pessimistic than it has been for much of this year. Corporate bond prices have fallen this year meaning yields have increased and look more attractive.
-1
Commercial Property Commercial property returns are continuing to slow but they are still providing a steady, positive return. Property continues to provide attractive diversification to equities and bonds.
-1
Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.
-5
Balanced Asset Allocation For a typical balanced portfolio we are underweight in fixed interest and neutral property. We are roughly neutral equity and also with additional holdings in defined returns and alternative equity.
A neutral score (=) means we expect the asset class to move in line with our long term assumptions: 10% pa for equity, 7% for property, 6% for fixed interest, 5% for residential property, and 3% for cash. A +5 score means we think the asset class could outperform by 50% or more. A -5% means we think it could underperform by 50%. A negative score does not necessarily mean we think the asset class will fall.
These represent Equilibrium’s collective views. There are no guarantees. We usually recommend holding at least some funds in all asset classes at all times and adjust weightings to reflect the above views. These are not personal recommendations so please do not take action without speaking to your adviser.
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.