Richard Stone provides some insight on the recent comments from The Bank of England
Bank of England now expects interest rates to rise more quickly
The Bank of England today, as expected, held rates at 0.5%. The focus of attention though was on the outlook and here the Bank of England clearly gave a steer that interest rates may rise more quickly than previously expected. This in effect signals that the next rise in rates is probably more imminent than had previously been thought.
Markets reacted with an immediate increase in Sterling against the US Dollar, but stock markets were relatively unmoved. In effect the pronouncement of the UK’s Central Bank merely confirmed what had been assumed in the US at the end of last week following strong economic data – namely that rates may rise more quickly than previously predicted. That had sent stock markets into something of a spin at the beginning of this week, although a sense of calm and normality appears to have returned since.
Commenting on the latest data, Richard Stone, Chief Executive of The Share Centre said:
The UK economy has continued to perform more strongly than had been expected and the latest reports from the Bank of England see an uplift in the growth forecast for 2018 from 1.5% to 1.7%. Inflation is expected to start to abate and wage growth is expected to rise signalling a return to real wage growth.
The return to growing real wages will be welcomed by households but from a Bank of England perspective they will start to signal greater strength in the UK consumer’s armoury and this should act as a further support to UK economic growth. A key part of the Monetary Policy Committee’s minutes refer to the ‘waning influence of external cost pressures’ but a continuing ‘recovery in domestic price pressures’. In other words, as we have commented on consistently for several months, the temporary inflationary impact of the devaluation of Sterling following the EU Referendum is now being replaced by more sustained domestic inflationary pressures and ultimately by more rapidly rising wages which underpin that.
In the face of these rising domestic pressures the outlook for inflation suggests it may stay above target for longer and the Bank of England will have to act. Hence the conclusion that rates will potentially have to rise sooner and more quickly than previously trailed.
The Bank of England also today released the letters exchanged between the Governor and the Chancellor following inflation going above 3% in the fourth quarter of 2017. This highlights that even in its central projection of rates rising to 1.2% (three 0.25% rises from today) in three years’ time, inflation would remain above target in years two and three of its outlook. The Bank’s remit has been to return inflation to target typically within a two year timeframe and in recent periods it has felt it can look over an extended period due to exceptional economic circumstances. The Governor makes clear in his letter that there has been a reduction in the ‘degree to which it is appropriate to accommodate an extended period of inflation above the target’. If economic forecasts to the Bank’s central prediction are borne out this must mean interest rates need to rise more rapidly than to 1.2% in three years’ time if inflation is to be brought back within target nearer to the two year time horizon. All of this speaks to rates rising sooner and more rapidly than the two further increases over three years anticipated by the Governor back in November 2017 when the last inflation report was published.
For investors, higher interest rates may have a suppressing effect on share prices in the near term as the flow of funds from cash to equities slows as cash becomes a more attractive asset, and the availability of cheap debt and stimuli through increased quantitative easing are effectively withdrawn. However, share prices typically do relatively well in times of higher inflation as they do not immediately lose value in the way that cash does. Fundamentally investors should not lose sight of the fact that this change in the outlook for interest rates is predicated on the strength of growth in the global economy – from which the UK is benefitting too. That should all be good news for companies, earnings and returns for shareholders.
The one note of caution is that more rapidly rising interest rates can expose those businesses which have gorged on cheap debt. As interest payments accelerate companies that have overstretched themselves may have difficulty coping with the burden they find themselves under. This was readily evident in the recent collapse of Carillion. For investors this highlights the importance of research and of holding a diversified portfolio. It also emphasises the value in seeking out companies with strong balance sheets and net assets – not just companies with high earnings driven by debt fuelled growth.
In our predictions for 2018 we forecast there would likely be more rapid interest rate rises than were being forecast. We also identified the likely return of volatility. This week we have seen markets reacting to newsflow and being more volatile. 2017 was an incredible stable year for markets with almost no volatility at all and investors and commentators need to adjust back to a world where volatility is a more normal daily occurrence. Along with higher interest rates this fundamentally represents yet another step back towards normality on the long road to recovery following the financial crisis of 2008.