Jamie Clark

Three reasons why UK rates are still heading higher

Jamie Clark

Jamie Clark: Three reasons why UK rates are still heading higher


Our Rising Rates
Macro-Theme is founded upon the belief that interest rates will rise as the scars of the Great Financial Crisis fade. We believe the last decade of low rates and disinflation will come to be seen as a temporary feature of the economic landscape and not a new equilibrium.

 

This outlook is contrary to the view of many: UK interest rate futures currently imply only a one in five chance of rates increasing to 1.0% by this time next year. Seemingly, the events of Q1 make higher rates look unlikely. March saw the European Central Bank revise its euro zone GDP forecasts “down substantially” and extend monetary accommodation; the US Federal Reserve reversed course and guided for no rate increases in 2019; and the Bank of England’s March minutes justified its own inaction on grounds of “Brexit uncertainties”.

 

However, central bank handwringing has not shaken our belief in the likelihood of tighter monetary policy. The Rising Rates theme presently accounts for 15% of the Macro Equity Income Fund via rate rise beneficiaries like large-cap UK Banks and also informs the Fund’s wider bias to short duration ‘value’ companies; businesses which, unlike long duration “growth” stocks, typically perform well as monetary conditions tighten.

 

There are three core strands to our argument for higher rates:

 


1. Brexit resolution will unshackle UK rates.

Irrespective of personal conviction, Brexit has been gruelling. For three years, its imponderables have dominated headlines and provoked some miserable assessments of the UK’s prospects (HM Treasury, take a bow [1]).

While the UK may not be booming, the economy has surpassed the gloomiest of forecasts. This is most apparent from the strength of the UK labour market. At 3.9% the unemployment rate is as low as it’s been since Status Quo’s ‘Down Down’ was number one in Q1 1975. The resultant labour market tightness explains why UK wage growth is running at 3.4% annualised; a pick-up on 2017’s 2.3% and 2009-2016’s modest 1.6%.

Jamie Clark: Three reasons why UK rates are still heading higher

For context, the UK jobs market is now as tight as America’s and wage growth is comparable, yet interest rates are 1.75% lower. This tells us that UK rates are liable to rise faster than many anticipate. Coming Brexit clarity, in any of several forms, should assuage reservations and allow the Bank of England to raise the base rate.


2. Inflationary population ageing.

Unlike Brexit, this trend is global and long gestation. That the world is ageing should be a given [2]. Less well understood, is that ageing is empirically connected with higher inflation. Research from the Bank for International Settlements (BIS) [3] shows that a growing working age population has reduced inflation by around 3% in the last 50 years (gold dotted line). The BIS projects that the coming increase in pensioners will increase inflationary pressures by around 3% (green dotted line).

Jamie Clark: Three reasons why UK rates are still heading higher

More pensioners implies more dependents and fewer workers. In turn, this suggest less disinflationary saving and more inflationary consumption. Any inflationary effects are amplified by the relative scarcity of workers and the corresponding pick-up in wage bargaining power. This should drive market rates higher as businesses borrow to invest and offset wage inflation, at precisely the moment that less saving means capital is scarcer [4].


3. Inflationary political actions.

We believe that persistently low rates, with their insinuation of weak economic growth, carry the seeds of an inflationary step change in government spending.

 

There’s a gathering sense that monetary policy can do little more. Critics maintain that low interest rates and quantitative easing have failed to revive growth, whilst stoking inequality and financial instability through asset price inflation. Some argue that come the next recession, the continued proximity of rates to zero means central banks are simply out of ammunition. Martin Wolf gives a neat summary of this view in a recent FT article.

 

Most responses to this issue cite fiscal expenditure as an alternative. Harvard economist Larry Summers is probably the most consistent advocate. His ‘Secular Stagnation’ theory paints low rates as a symptom of deficient private sector demand. To stave off permanent damage, Summers recommends stimulating economies through government spending on infrastructure projects[5].

 

The growing interest in fiscal policy is clearest from the buzz surrounding Modern Monetary Theory (MMT). This is an idea associated with left-wing US Democrats like Bernie Sanders and Alexandria Ocasio-Cortez. Reductively put, MMT claims that governments can spend without debt constraints because they can always print more money to service their debt[6]. The clear drawback is that uninhibited government expenditure will ultimately bring higher inflation and bond yields. The lessons of the 1970s tells us that this risk is shared by Summers’ more orthodox Keynesianism.

 

Taken together, we expect these three thematic components underpin Rising Rates. The rate-sensitive banks held by the Fund provide an excellent way to capture this change.

[1] HM TreasuryHM Treasury analysis: the immediate economic impact of leaving the EU, May 2016.

[2] WHOWorld Report on Ageing and Health, 2015.

[3] BIS, Juselius and Takats, The enduring link between demography and inflation, May 2018.

[4] BIS, Goodhart and Pradhan, Demographics will reverse three multi-decade trends, August 2017.

[5] Brookings Institute, Rachel and Summers, On Falling Neutral Real Rates, Fiscal Policy and the Risk of Secular Stagnation, March 2019;

[6] New York Times, Paul Krugman, What’s Wrong With Functional Finance, 12/2/18.

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Key Risks

 Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Macro Thematic team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The Fund’s expenses are charged to capital. This has the effect of increasing dividends while constraining capital appreciation. The performance of the Liontrust GF Macro Equity Income Fund may differ from the performance of the Liontrust Macro Equity Income Fund and is likely to be lower than its corresponding Master Fund due to additional fees and expenses.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Tuesday, April 9, 2019, 10:51 AM