UK fiscal and monetary policy offset to kick in, bullish for gilts

UK Chancellor Osborne has now abandoned his 2020 budget surplus target. Combine this with the dovish statements by Bank of England governor Mark Carney yesterday and you can see some serious policy changes in play to minimize the near-term downside risk. But, of course the risks to the UK are longer-term and the near-term risks are mostly elsewhere in the global economy. I continue to believe this favours safe assets i.e. government bonds.

Now Osborne is doing his level best to maintain consistency but it is clear his rhetoric has changed significantly. Before, the referendum, he promised to tighten fiscal policy and now we realize this simply isn’t going to happen. Instead, due to near-term growth concerns, we are getting a coordinated blitz of monetary and fiscal stimulus – as we should have expected. After all, fiscal and monetary policy aren’t decided in a vacuum; they are used to offset significant changes in the prospects of the private sector. Osborne even admits this himself:

“As the governor [of the Bank of England] has said: the referendum is expected to produce a significant negative economic shock to our economy. How we respond will determine the impact on jobs and growth.”

Here is what the Bank of England governor Mark Carney is saying (pdf here):

In May, the MPC judged that a sustainable return of inflation to the 2% target probably required a gradually rising path for Bank Rate over the next three years as growth picked up, jobs and wages increased and the drags from a stronger currency and lower commodity prices faded.

As required by its remit, the MPC has already described how a vote to leave the EU could materially alter the outlook for growth and inflation.

As a result of increased uncertainty and tighter financial conditions, UK households could defer consumption and firms delay investment, lowering labour demand and causing unemployment to rise. Through financial market and confidence channels, there are also risks of adverse spillovers to the global economy.

At the same time, supply growth is likely to be lower over the next three years, reflecting slower capital accumulation and the need to reallocate resources across sectors of the economy. Both of these forces may be exacerbated by higher uncertainty and tighter financial conditions.

Finally, as expected, sterling has depreciated sharply. For given foreign demand, this will mean support to net trade, though this may well be dampened by uncertainty around future trading relationships. A lower exchange rate will also entail higher prices for imported consumer goods, energy and capital goods, and consequently lower real incomes. As the MPC said prior to the referendum, the combination of these influences on demand, supply and the exchange rate could lead to a materially lower path for growth and a notably higher path for inflation than set out in the May Inflation Report. In such circumstances, the MPC will face a trade-off between stabilising inflation on the one hand and avoiding undue volatility in output and employment on the other. The implications for monetary policy will depend on the relative magnitudes of these effects.

Basically, he expects private sector UK growth to be weaker both because of weaker consumption and weaker investment and, therefore, anticipates that the Bank of England will provide sufficient monetary policy offset to deal with whatever level of short- to medium-term economic shock the referendum vote creates. Osborne is effectively making the same point. The only questions now are whether there actually is any private sector growth slowdown and whether the Treasury and Bank of England provide enough fiscal and monetary policy offset to deal with the situation.

As I wrote on Wednesday, my base case scenario is that there will be minimal medium-to longer-term impacts on the economy and earnings. This is in part because the currency and monetary and fiscal offsets will stabilize growth. Other people are talking about an outright recession. But I see this as more motivated reasoning that doesn’t take into account the currency, fiscal and monetary offsets.

Moreover, I don’t foresee a massive move lower in the UK’s exchange rate. We could hit as low as 1.20 to the USD but that move will be mitigated by a fall in the euro which is almost 50% of the UK’s exchange-weighted exchange rate value. The US dollar is much less important. As a result, I do not see shares in the UK declining significantly. And the FTSE has already re-couped all of its post-referendum losses. But it is still early days. So we will have to wait to see what the impact on earnings really is before we can gauge the damage.

My real concerns over the short-term are elsewhere: in European banking with Italian banks and with Deutsche Bank, whose shares are at 30-year lows, and in a strong US dollar.

Longer-term, the first worry has to be a deflationary global growth slowdown. We are seeing a huge move lower in government bond yields now. The US 10-year is at 1.405% and the UK 10-year is at 81 basis points. And while much of this is a safe haven bid, the fact that equities have rallied at the same time that bonds have rallied means that these markets are sending very different signals. My view is that the equities signal is a short-term one about a snapback from oversold levels and an overreaction to the referendum. Where equities go over the medium-term is not clear, especially given the existing global growth slowdown and the weakness in earnings in the US in particular. Bonds are saying, “fellas, wake up, the yield curve is flattening because the longer-term growth potential is weakening; inflation expectations are weakening – and rate hike expectations along with them.”

For the UK, the losses are longer-term i.e. trade. It is difficult to put a number on the loss but to the degree tariffs and trade frictions are higher – and they almost certainly will be – we are talking about an almost-permanent loss, meaning an annual decline in growth relative to where it would otherwise be. Now, of course, one could make the case that the ‘Leave’ position of pivoting to the US and emerging markets will mostly offset those losses. I don’t have a view on whether that is credible over the longer term. But over a two- to five-year time horizon there will be pain – modest, yes, but still some pain.

In the end all of this spells, monetary and fiscal offset. And to me that is government bond bullish. And the positive bond outlook is not just for the UK, but for all developed countries. Watch the Anglo-Saxon government bonds in particular – that’s  US, UK, Canada, Australia and New Zealand – since they have the furthest to fall toward zero. The longer-term convergence to zero play I first outlined at the beginning of 2015 is still occurring.

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