Bank of England acted faster than most economists expected

In this week’s bulleting:

  • Another volatile week saw two days of negative sentiment forgotten, as eurozone fears softened and positive US data drove equity markets upwards
  • Where next for the eurozone? This week, France and Germany will meet to settle their debate over who foots the bill for the multi-billion euro bailout of Dexia.
  • The Bank of England acted faster than most economists expected, when they announced a second round of Quantitative Easing. What does this mean, and what are the implications?
  • Inflation remains stubbornly high, and looks like it will remain an issue to savers with interest rates predicted to remain low until 2013


The week that was

Another volatile week saw two days of negative sentiment forgotten as eurozone fears softened somewhat and positive US economic data drove equity markets upwards. The FTSE 100 gained 3.4% on the week, despite 12 UK lenders being downgraded, including Royal Bank of Scotland, Lloyds Banking Group and Nationwide Building Society. European and US markets also gained in excess of 2.5% for the trading week.

The week began badly with Greece unable to cut its budget deficit to 7.5% of GDP, and rumours that European leaders were pushing for a further haircut on the value of Greek debt. However, the equity markets showed resilience on the back of more positive news. US unemployment decreased with 103,000 new workers being nearly twice the number expected, while plans by European Union leaders for a co-ordinated recapitalisation of the banking system triggered a sharp turnaround. In addition, both the BoE and the European Central Bank announced support for markets, helping global equities to their largest three-day rally since April 2009.


Where next for Europe?

Despite equity markets reacting positively towards the plans for European bank re-capitalisation, it is important to recognise the discussions are only just beginning and will require governments across the eurozone to inject huge amounts of capital into the financial system. This could be the start of a solution taking years to flow through, but it seems that all investors wanted was a sign of co-ordinated action amongst European political leaders, something that has been lacking throughout 2011, to create a surge in demand for ‘risk’ assets.

This week it is expected that France and Germany will continue their attempts to settle the debate over who foots the bill for the multi-billion euro rescue. Nicolas Sarkozy and Angela Merkel will discuss how to protect Europe’s banks against the break-up of Franco-Belgian bank Dexia, the troubles of which has added pressure to act. The debate stems from Germany’s belief that the European Financial Stability Facility (EFSF) should only be used when national resources are exhausted, with the concern being that if one of the strongest members, France, uses the bail-out then the floodgates will open for the whole eurozone to follow. Furthermore, as a result of Belgium pledging further capital to help support Dexia, the troubled Franco Belgium bank, Moody’s unhelpfully put the country on ‘negative’ watch facing a review for a potential rating downgrade. France’s desire to protect its top-notch credit rating is believed to be the reason that it is pushing for access to the €440 billion EFSF.

In the light of the negative headlines surrounding Europe, we asked Stuart Mitchell of S.W.Mitchell Capital, about the future of the eurozone. “We think a solution will be sooner rather than later. We’ll get a resolution in Greece and in fact, we’ve got some sort of promise from the ECB who suggest they are going to give unlimited funding. Hopefully, we are going to see a stability pool of capital in order to soothe the market’s problems. A pool of capital that can buy government bonds to keep the markets calm. That’s quite a big assumption of ours, but we think it’s more likely than not. The alternative is just too difficult for anybody to comprehend. The German political classes have always believed in the Euro in the long term, whatever the short-term cost. But the arguments against the Euro in the German public press are dying down because, at the end of the day, most realise that a weaker Euro in the short term has really helped German industry. I think most people understand that the cost of saving Greece, Ireland and Portugal, within the context of the wider European Union, isn’t that great. And the alternative, in terms of the complexity of trying to undo it, is enormous and would have a dramatic impact on growth in Europe, as well as the global economy.”

When asked about the long-term future of European equity markets, Stuart was positive “One point we continually make is to look at the quality of the European corporate sector, and how much it has improved over the last 20 years. Levels of profitability are now higher than in 2007 before the crisis, even with GDP well below its peak. We need to go back 40 years before companies start looking as cheap as this, and it’s very rare to find a combination of cheap stocks, strong balance sheets and good dividend yields. In 25 years working with European equities, I have never seen people as bearish as they are right now, with some people not even able to speak the words ‘European equity’. But the reality is that when you are meeting with these companies, and looking through their balance sheets, there are many causes for optimism. The problem is more a political one, and in terms of levels of debt, the European debt should be more manageable than the US one.”

Stuart has held a significant weighting in France and Germany, describing them as the powerhouses of Europe. When discussing the future of Germany as a stand-alone economy, he opined “The German domestic economy will surprise a lot of people going forward. The big issue in the UK and the US was that of consumers spending too much on credit cards, but in Germany over the last 20 years, consumer spending has hardly grown and the savings ratio has stayed at 15% throughout this time.”


QE2 returns to the UK early

On Thursday the Bank of England (BoE) acted more swiftly and more decisively than expected, injecting a further round of stimulus into the UK economy. The Monetary Policy Committee voted for the first time since November 2009 to increase its purchases of gilts by an initial £75 billion over the next four months. Many economists expected this action in November, a traditional month for decision-making, but the step was taken early. Reflecting, the Bank’s Governor, Mervyn King, commented that global economic prospects had deteriorated over the last three months, and declined to rule out further gilt purchases. It is clear that recent economic data convinced a majority of members of the need to act without delay.

While much has been spoken of Quantative Easing, readily understandable explanations of exactly how the BoE expected it to work have been in short supply. So what does Quantitative Easing actually mean, and why is there a need? The theory behind the move is that the BoE steps into the market and buys gilts from private institutions such as banks, insurance companies and non financial firms. Recipients of the funds have more money to spend or invest in assets such as equities, commodities, corporate bonds thus boosting economic growth and/or the price of those assets. Rising asset prices makes people feel better off and encourages further spending this creating a virtuous circle. In addition, the purchase of gilts and other assets reduces the yields and consequently long term interest rates and the cost of borrowing.

The theory goes further and suggests any money deposited with banks would improve their funding and consequently their willingness to lend money to individuals and businesses.

Of course, as seen in March 2009, there is nothing forcing the banks to lend to anyone, meaning that the impact is muted if the banks hoard the increased capital. There is also the argument that the increase in money supply will have the effect of keeping inflation higher than might otherwise be the case as the money filters down to the general public to start spending again. The BoE statement claimed the justification is weak global growth and the sovereign debt crisis in Europe, and that buying gilts was deemed necessary to boost economic growth “in order to keep inflation on track to meet the 2% target in the medium term”. However, most economists are still unsure how this will pan out, while the Financial Times ran an editorial claiming “Doing something is better than doing nothing, but £75 billion will boost output by 0.75% at best. The BoE and European Central Bank (with the ECB offering short-term loans to banks) chose more of what each was already doing. That is better than nothing, but even more would be better still”.

Many economists expect this to be the starting point. Unless the news on the economy improves markedly, it seems unlikely that the MPC will conclude in four months that it has done enough. It should be remembered that the first bout of Quantitative Easing was extended three times from an original £75 billion to £200 billion. In terms of the likely impact on the economy, according to Jonathan Loynes of Capital Economics, the evidence from QE1 is somewhat mixed. “The original purchases appear to have reduced gilt yields, but the key objective was to increase the amount of money and credit in the system. However, this was severely hampered by the dysfunctional state of the banking sector, and the impact on this has been minimal. It is impossible to know exactly what would have happened without QE, but Mervyn King insists that GDP would have contracted far more sharply, and the announcement may well reassure companies that interest rate hikes are a very distant prospect.”

The immediate reaction by financial markets was for gilt yields to fall, with 10-year yields falling to 2.23% at one point, near the 100-year low according to BoE data. Sterling fell to its lowest level against the dollar since July 2010, immediately dropping 1.3% on the news. Where equity markets are concerned, share prices on both sides of the Atlantic pushed upwards amid the announcements, with financial stocks particularly buoyant.


Who will it affect most?

It is now widely accepted that with the BoE latest move, interest rates are going to stay lower for longer, affecting savers already facing poor returns and an increasing difficulty in beating inflation. It is now highly likely that interest rates will remain low until 2013 at the earliest, but there are now only a handful of accounts that produce real returns after tax, with the Consumer Price Index at 4.5% and Retail Price Index at 5.2%. The Bank still believe that CPI will reduce to below the targeted 2% in the medium term, though there is always scepticism given the inability of the Monetary Policy Committee to hit its inflation target over much of the last 5 years, but even savers with index-linked products could well see their returns lower than expected over the next three to five years if the Bank are correct.

Since the first round of Quantitative Easing in March 2009, yields on government bonds have fallen from 4.38% to 2.83%, pushing down the benchmark annuity rate from 6.24% to 5.49%, according to figures from the Better Retirement Group. It would be expected that the same effect will be felt again, at a time when the amount of income retirees can buy is already at a record low. Insurance companies use gilt yields to determine how much income they can offer over the long term, so the impact of Quantitative Easing will  seemingly affect everyone.

Inflation has always been an issue, even when the figure is not as high as the level the UK is experiencing now. It is often easy in the short-term to overlook the adverse effect it has on capital and income. Inflation does not reduce the monetary value of the capital, just the purchasing power of it. To demonstrate this, the chart overleaf shows that over the last 19 years with inflation at perceived low levels, capital would have lost around 42% of its purchasing power.


With inflation even higher, it is even more important to invest in real assets over the long term, with equities and commercial property offering the potential to combat inflation. Undoubtedly, volatility will continue as markets react in an exaggerated manner to the latest piece of economic data (both good and bad) and political leaders finally begin to grapple with a resolution to the sovereign debt crisis. Our advice remains to build a diversified portfolio, as yields on high quality bonds and property are significantly higher than those found in cash, while as Stuart Mitchell outlined previously, blue chip equities are very attractive based on historic

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