18th July 2017

Rathbones weekly review: Will they, won’t they?

Another season of that riveting game show is under way: Know Your Central Banker.

How hawkish is European Central Bank head Mario Draghi? How dovish is Federal Reserve Chair Janet Yellen? Will Bank of England Governor Mark Carney be happy to support a hiking trip if his committee leans that way?

You could spend all day reading monetary policy minutes and watching for tell-tale eye twitches during speeches at monetary policy galas. Central bankers have to try to coax the most fickle, schizophrenic social system on Earth to get on board with what they may or may not do at some point or perhaps later. The secret appears to be keeping your words so vague that people can hear whatever it is they want to hear. That way, no-one panics.

As exciting as central-banker spotting is, we believe rate rises have little effect on equity markets. Our research shows that the FTSE 100 in particular is hardly deterred at all when the BoE starts to tighten interest rates. The FTSE 250, which is more UK-focused, doesn’t do quite as well but still holds its own. Rates typically rise because the economy is doing well and central bankers are trying to stymie inflation. The mechanics are relatively straight forward: investors can get higher interest rates from safe bank (or gilts) so they expect higher returns for taking risk on a business. All else being equal this leads investors to value each pound of cash flow less than they did before. However, earnings tend to be rising because the economy is doing well and this greater volume typically more than offsets the effects of lower-value cash flows. Therefore, all else being equal, share markets should rise too.

Rising interest rates do have a negative impact on bonds, however. And we have already unimpressed with gilts and treasuries for some time now, given their record low yields (and therefore record-high prices).

Last week, the Bank of Canada increased its benchmark interest rate by 0.25 basis points to 0.75%. Many investors are worrying that this signals a wider global shift toward tighter monetary policy that will hurt returns. We think it’s great news that Canada, for the first time in seven years, is healthy enough to start normalising its borrowing rates.

When central bankers don’t have to play the game, when they don’t have to be vague, that’s progress.

Source: FE Analytics, data sterling total return to 14 July

Soft currencies and hard-liners

All major share markets rose last week, although sterling investors would have seen losses for the S&P 500 and Shanghai Composite.

That’s because the pound hit its highest level against the dollar in 10 months: $1.31. Or, more accurately, the dollar weakened sharply after US inflation slipped even further than investors expected to 1.6% in June. Just four months earlier it was 2.7%. American consumer confidence continues to leak away too. The probability of another US interest rate rise in 2017 slipped below 50%, according to Fed Funds futures. Instead of December, March is now looking more likely.

Will sterling hold onto its newfound (and sadly relative) strength? Probably not. The pound has a history of flinching whenever Brexit negotiations reopen. It’s probably algorithms reacting to the number of Brexit mentions on Bloomberg headlines, but sterling does feel frail all the same. We believe the pound is significantly undervalued on a long-term view, but currencies are arcane and there are few obvious catalysts for a resurgence.

It doesn’t help that there appears to be a rift in the UK Cabinet between hard-line Brexiteers and moderates. In a BBC interview, Chancellor Philip Hammond implied some ministers were leaking damning details and comments on austerity and the public pay freeze in a bid to squeeze him out. Mr Hammond, an unabashed remainer, has been adamant about the need to hold the line on austerity. With Brexit looming, the government should keep as much money as possible in reserve in case a fiscal injection is required, he argues. The front line of this fight is public sector wages, which made up half of day-to-day spending in 2014, according to a report by the Institute for Fiscal Studies.

It is difficult to boil down public versus private earnings to a simple average, however. Mr Hammond is correct that overall, the average public sector wage is higher than private workers enjoy. However, the public payroll is overwhelmingly female. Government workers are also more likely to be more highly educated than the private sector workforce. And older. When all these factors were adjusted for, government men were paid the same as company men in 2014. Women were paid 8% more than their private sector counterparts. But this makes sense

when the government is leading the charge in trying to correct a long-standing gender pay imbalance.

It is a shame that proper debate about the merits and trade-offs of government policy are being stifled and undermined by partisanship within the government.

Bonds

UK 10-Year yield @ 1.31%

US 10-Year yield @ 2.33%

Germany 10-Year yield @ 0.59%

Italy 10-Year yield @ 2.29%

Spain 10-Year yield @ 1.65%

Julian Chillingworth
Chief Investment Officer

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Investment Commentary