Economic and market briefing: the UK in focus

At the 4th Local Authority Treasurer’s Forum, yesterday, I discussed the outlook for the UK economy and markets with Marian Bell and Philip Booth, in a session chaired by Phil Triggs of Surrey County Council. Whilst it’s easy to be gloomy about economic conditions, it interesting that macro indicators show that the UK is performing better than other key economies (Euroland and the US) based on Purchasing Manager (PMI) new order surveys, retail sales, employment, investment intentions and the household savings ratio. Even housing is stabilising. As a consequence economic surprises are more positive than in any other region.

The UK macro economy is clearly helped by relatively dovish central bank policy, and there is good co-operation between the Bank of England (BoE) and the Treasury. For example, the recent £80bn funding for lending scheme involves accepting 5% of non-financial private sector loans for collateral and 100% of the increase in lending for a potential cost of as little as 0.25%. As collateral, the BoE would accept loans to the real economy. The Treasury and the Bank of England anticipate that this additional funding, together with auctions of six month liquidity through the Bank’s Extended Collateral Term Repo Facility, will boost lending to the non-financial sector by between £80 and £100 billion, and has drawn positive comments from the Fed Chairman Ben Bernanke. Lloyds is reported (Telegraph, 20th September) to have become the first lender to use the FLS, taking an initial £1bn. The FT (September 9th) report that the FLS has reduced banks’ funding costs by 50bps.

It is noteworthy that The Chancellor announced in his Mansion House Speech that it will become a legal requirement for the Bank of England’s Financial Policy Committee to detail how every action it takes is compatible with economic growth as well as stability. This has now become a secondary objective for the FPC (‘we don’t want the stability of the graveyard’). The FPC is in the process of taking over regulation of UK banks from the FSA.

It’s also helpful that the BoE’s Monetary Policy Committee (MPC) can take a long term view because the next General Election is not until May 2015, and the political stability of the UK is positive relative to many Euroland countries and even the US. The current government’s 5 year term is confirmed in law under the Fixed Term Parliaments Act and under this act, an earlier election can only occur following either a vote of two thirds of parliament in favour, or following a motion of no confidence with no alternative government found.

As for QE, as a gauge of the activity levels of the BoE, 28% of government bonds are now owned by the BoE, rising to 30% after the additional QE is complete, and in contrast the US Federal Reserve holds 15% of US Treasuries and the Bank of Japan holds 10% of Japanese Government bonds.

On the government policy front, fiscal tightening is less than elsewhere. The government has already pushed back the elimination of the structural budget deficit by 2 years (from 2015 to 2017) and fiscal tightening this year is now 0.3% compared to initial plans of 1.2% (lower than in the US or Europe).

Meanwhile, sterling is a potential safe haven and is one of the cheapest non-Euro European currencies. Marian reckoned that the pound was expensive, but it’s only close to fair value on OECD purchasing power parity (PPP) estimates, where as other safe haven currencies are overvalued by between 25% and 60%.

As for strategies and investment market conditions, interest rates can only be expected to stay low for the foreseeable future and with the need for negative real yields on bonds (eg nominal yields less inflation must be zero), we can expect that the 10 year index-linked bond yield is set to fall further. Indeed we think that the 10-year index-linked bond yield will fall from minus 1.0% to minus 1.5% because only at that level do the government debt to GDP ratio and the unemployment rate stabilize. Put simply, negative real yields are an essential part of the medicine for dealing with the over-indebtedness and de-leveraging requirements, and although many investors assume that positive real rates are the norm, it’s a useful reminder that negative real interest rates can persist for an extended period –  between 1942 to 1955, real 10-year bond yields averaged -3.5%. put another way, if the real bond yield was close to its historic norm of 3%, rather than the current -0.8%, the US government would have to engage in additional fiscal tightening of around c4% of GDP to stabilise its debt-to-GDP ratio.

Exploring the issues in more detail, Philip made two key points. First, that as a result of Vickers and other initiatives banks can and should be allowed to fail and in such circumstances, the strategy must be to diversify, diversify and diversify. We should add that it also means that a gimlet eye must be kept on balance sheet strength and resilience, suggesting that for many treasurers, a money market fund is a smart option to consider.

Philip’s second point was that in an environment of very low money rates and bond yields, treasurers should sensibly explore the case for risk assets where they have the opportunity to take a long term view. Over the lunch break, our own John Kelly echoed the point in considering real estate, with the point well made that if the rental yield return from a well diversified spread of good quality commercial properties was a heady multiple of the yields available from cash, the downside risk protection for the properties in effect offered by the excess returns could be construed as attractive, particularly as the time horizon is extended, and the income margins compound.

This leads on to a question as to what should the ‘fair’ yield from commercial property be in a climate of low money rates. The gap between the index linked bond yield and the IPD yield, as a proxy for UK commercial property overall, of 6.3% is now extreme, and arguably the warranted yield on commercial property is 4.9%, based on current inflation linked government bond yields and adjustment for risks and rental growth prospects. Properties are not a homogenous asset class by any means, but a well selected portfolio of properties or an appropriate diversified fund may be seen as cheap and could offer attractive long term returns. The ‘bull’ case for property as an asset class has some technical support too. Thus, insurance companies may choose commercial property investment as a preferred inflation hedge relative to equities, given that, under Solvency 2, the capital requirement for direct equity investments is about 10 percentage points higher than that for commercial property.

To end on a distinctly optimistic note, co-operation between fiscal and monetary policy is key to the recovery in the developed world – and in the UK, this cooperation is better than for any other major country, and the Financial Policy Committee have been given a secondary objective of growth!

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla