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ECB tapering and economic growth slowing

28 July 2017

What are your thoughts on the European Central Bank tapering and subsequent interest rate rises? How will markets react?

This week five years ago, Mario Draghi said that the European Central Bank (“ECB”) would do “whatever it takes” to preserve the Euro currency. At the time, the German 10 year bond yield was 1.26% but Spain and Italy yielded much more: 7.37% and 6.44%. Since then, Draghi has been true to his word, taking interest rates negative two years later and buying bonds. Greece has received substantial support and today the Eurozone is in much better shape than it was. The reduction in interest rates has saved a substantial amount in interest payments for Eurozone countries, for example Spanish and Italian bonds now yield 1.51% and 2.08% respectively. While structural reform has made progress in some countries, others have been slow to make progress and the Eurozone is far from booming. Indeed, some argue that the reduced interest rate has removed the urgency to reform. The ECB targets inflation at 2% and while inflation has picked up, it is still below the target level. Despite this, the ECB has indicated that it may discuss reducing its bond buying programme later this year. In response the euro has risen in value. A rise in the currency reduces the international competitiveness of the Eurozone and reduces inflation, making actual rate rises less likely. However, with negative rates eventually they will want to move rates less negative. The aim will be to raise rates in response to a stronger economy and with inflation stubbornly low, they will not want to damage asset prices by raising rates too fast. At LGT Vestra, we therefore feel that bond buying will be reduced first and rate rises may well not come before the end of next year. In any event, we see it as a response to better economic conditions and not necessarily a threat to equity markets in the near future. After all, the US Federal Reserve has raised rates four times and the S&P 500 Index is close to all time highs.

The latest UK GDP numbers show economic growth is slowing, are we finally seeing the impact of the Brexit growth?

Next week it will be a year since the Bank of England (“BoE”) cut interest rates and announced a bond buying programme in response to the Brexit vote. Economic data in the second half of last year surprised them by being better than they originally feared. The latest GDP numbers indicate that there has been a slowing in the pace of growth since the end of last year. Both sides of the Brexit debate overstated their case; George Osborne in the Remain camp warned of redundancies starting the week after the Brexit vote and the need for an emergency budget. The scare tactics suggested imminent economic collapse. The Leave campaign made light of the Brexit negotiations and the economic impact. The argument appeared to be that the UK was so important the European Union would be keen to do a trade deal and made much of the savings we could get without any costs. My own view was that we could be better off five years after an exit but that the cost in the meantime would be high. Some have claimed that the strength of the UK equity market is an indication that all is well but we need to remember that since the middle of last year the global equity markets have been positive and about 70% of the earnings of FTSE 100 companies comes from overseas. Following the Brexit vote and the BoE rate cut, we saw a sharp fall in the currency which boosts overseas earnings in sterling terms and enhances UK competitiveness relative to the rest of the world.

The fall in sterling is a double edged sword. While it helps the economy and equity market initially, it pushes inflation higher. The impact on inflation has been slow to come through as retailers appeared reluctant to pass price rises through. As a result, the impact is being felt this year as inflation rises faster than both wages and the BoE’s 2% target. The majority of the Monetary Policy Committee see this as a temporary impact on inflation and have, so far, kept rates on hold. Last month, the Governor Mark Carney warned that they could remove some of the stimulus measures they had put in place. They have particularly warned about the rise in consumer debt and have changed the rules on banks’ ability to lend. Since then, we have seen wages rising slower than prices and this has started to constrain consumer spending. The latest GDP numbers are an indication that this, combined with the uncertainty around Brexit, is having an impact.

So to answer the question: the impact of Brexit may have been delayed by the devaluation and the cut in interest rates but does now appear to be being felt. There may be benefits from leaving the EU but these will take a long time to come through. Our expectations are that growth will be sluggish in the UK until there is greater clarity on investment. However, one swallow does not make a summer and two quarters of slower but positive growth do not make a recession. On interest rates it is possible that the central bank take back the emergency Brexit rate cut in the next year but I believe they would be unwise to do more than that unless conditions improve significantly.



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