Re-calibrating our thinking about Brexit after MPC rate cut

The Bank of England has cut interest rates and started a quantitative easing program that includes both government and corporate bonds. This approach was enough to send the pound Sterling down to $1.31 and 10-year gilt rates to a record low of 0.677%. While I reiterate my previous bullish views on Anglo-Saxon long rates, US dollar strength and on the UK avoiding recession, I want to put the MPC rate decision in both the UK and global context of secular stagnation.

Before getting into implications, let’s review what just happened. After the UK voted to leave the EU, the Bank of England stood pat in its first Monetary Policy Committee meeting in July. However, given the horrific numbers coming out of the UK economy since that time, the Bank of England decided not to wait any longer and put forward a monetary stimulus package that included a base rate cut from 0.50% to 0.25% and £70bn in quantitative easing, comprising £60bn in gilt purchases and up to £10bn in corporate bond purchases. Bank of England governor Mark Carney told the press after the decision that “there is a clear case for stimulus and stimulus now.” He also tried to reassure by saying, “on all elements of this package, we have scope to add” if necessary, due to economic weakness.

So that’s what we got. And the market response was to send Sterling and gilt yields down sharply, suggesting the BoE actions were more aggressive than anticipated. But will it be enough?

My thinking remains the same about the base case. As I put it in late June: “My base case scenario is that there are minimal medium-to longer-term impacts on the economy or earnings. I don’t foresee a massive move lower in the UK’s exchange rate or higher in US exchange rates. I also do not see a huge decline in shares going forward. For the UK, a lower currency actually aids the Bank of England in its fight to boost inflation toward target. And it might also have some mild boost to exports and tourism as evidenced by.” And this is due to the fact that fiscal and monetary policy will offset economic weakness. The Bank of England also takes this view based on the central tendency of its growth forecast.

Now, notice that while the central tendency yields unchanged 2% growth for 2016, growth is down to 0.8% from 2.3% for 2017, and in 2018 at 1.8%, down from 2.3%. Overall the BoE expects the Brexit hit to be 2.5% of GDP over three years.

But if you look at the reasonable worst case scenarios for 2017, they include recessions, meaning the UK could indeed have a recession in 2017, depending on the circumstances, though this is not their base case. Many private sector economists are worried about recession. For example, the National Institute of Economic and Social Research – an economic think tank – says that Britain’s economy will shrink this quarter already and that it has a 50 percent chance of suffering a mild recession before the end of next year – and they blame the Brexit vote. Clearly then, recession is a base case here for the NIESR.  I don’t see it. But if true, it only bolsters the case for curve flattening in the UK that makes long-term government bonds relatively more attractive.

The fact is that irrespective of whether the UK enters recession, the global economy is relatively weak and an uptick in inflation is nowhere on the horizon. One could reasonably talk of secular stagnation, a situation in which nominal and real growth rates in the developed world are in secular decline. Gavyn Davies has some positive news on that score:

The latest Fulcrum nowcasts for global economic activity have identified a broad pick-up in growth in many major regions, both in the advanced economies and the emerging markets. The latest estimate shows global activity expanding at an annualised rate of 4.1 per cent, a marked improvement compared to the low point of 2.2 per cent recorded in March, 2016.

The synchronised nature of this improvement in growth is notable. Not only have the risks of a global recession in the forthcoming months fallen sharply, there are now some early indications that the world economy could be moving into a period of above trend expansion for the first time since early 2015.

If this improvement continues, it might suggest that the global economy is achieving “escape velocity”, in which the recovery becomes self-propelled, without needing repeated doses of monetary and fiscal policy support to prevent a renewed slowdown.

However, in view of the frequent disappointments about growth that have occurred in recent years, and the apparent stranglehold that “secular stagnation” has exerted over some parts of the global economy, it would be foolhardy to reach a firmly optimistic conclusion on this at the present time. For now, we would simply note that the activity data have improved since the low points were reached early in 2016, and that global deflation risks are falling.

Let’s see how this pans out. But for now, if I had to re-calibrate on Brexit, I would say the near-term risks in the UK are acute enough to draw a strong response from policy makers. It has now done so on the monetary side. We await a fiscal response. UK Chancellor Hammond said in response to the BoE decision that he is “prepared to take any necessary steps to support the economy and promote confidence,” suggesting a fiscal response is coming. Will he cut VAT rates in the UK or boost infrastructure spending? We don’t know. There is a possibility that he moves up his Autumn Statement to October, however, in order to get in front of any downside risk to the economy. And the possibility of this response leaves me still thinking Brexit will have a muted impact on the UK economy.

Meanwhile in Europe, one thing that was interesting in yesterday’s data was that the Brexit vote is not having an effect on the Eurozone’s PMI numbers. Markit’s final composite PMI figure to measure of growth across the eurozone— was 53.2 – which is a decent number. The damage of Brexit is localized to the British economy. If Brexit were a real problem, one would expect to see it show up in the numbers of export-dependent economies like Germany’s. It hasn’t and I believe that means the immediate shock of Brexit will soon pass and have minimal longer-term impacts on consumption and employment in the UK. However, if we do see UK employment and consumption hit from downside domestic implications, then the EU – which exports a lot to the UK – will get hurt too. Overall though, the UK is not a huge player in global growth. So the first order effects of Brexit should be relatively low. It is the second order effects in terms of re-appreciation of tail risks in Italy or in a strong dollar or in lower oil prices that make Brexit dangerous for the global economy.

Despite Gavyn’s upbeat message, I believe real and nominal growth in developed economies will continue to be weak, particularly in the eurozone where fiscal responses are more limited by institutional arrangements. And as a result, I continue to favour long-dated Anglo-Saxon – i.e US, UK, Canada, Australia and New Zealand – government bonds in particular since they have the furthest to fall toward zero. Rate cuts like the one in Australia two days ago and like the one in the UK today will be coming in Anglo-Saxon countries. So, the longer-term convergence to zero play I outlined 18 months ago is still occurring.

The big new risk re-emerging here is policy divergence. It is as a great a risk now as it has been at any time in 2016. I continue to see $1.20 as a downside level for the Pound. Parity to the euro is also within reach. Potential rate hikes in the US while the rest of the Anglo-Saxon world is easing and other developed economies are below zero will move the dollar up and hurt US dollar debtors with non-dollar revenue streams. That’s bad for emerging markets and it’s bad for oil and commodity producers. It is bad for US energy capex as well, something that will make rate hikes come to be seen with hindsight as a policy error.