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UK interest rates and equity volatility

20 April 2018

Has this week’s economic data changed the outlook for UK interest rates?

At the start of this week, it looked as though interest rates would be moving up next month when the Monetary Policy Committee ("MPC") meets. With inflation remaining above the 2% target, two MPC members previously indicated that they wanted to raise rates and recent rhetoric appeared to be preparing the market for an imminent move. This week we have seen inflation, wage growth and retail sales data all coming in weaker than expected. Following on from that, the Governor of the Bank of England ("BoE"), Mark Carney, commented in an interview that we should be ready for a few rate rises over the next few years but was more opaque surrounding the timing of the next hike.  

As the country enjoyed the sun coming out this week, let us not forget that the start of March was marked by heavy snow across the country. The impact of the weather effects is hard to forecast so this may explain some of the weakness in retail sales. The Consumer Price Index fell from 2.7% to 2.5% versus the Bloomberg survey predicting that the number would remain. Looking through the data, the main contributors to lower price pressures were in energy, women's clothing and travel costs. The survey is taken in mid-march and are thus ahead of the Easter holidays that usually see travel costs rise. Better weather may boost clothing sales and the oil price has been moving up so this could be a timing issue. The devaluation of the pound following the Brexit vote boosted inflation, as this effect fades out of the annual data inflation should pare back. Whilst the wage data was modestly disappointing, weekly wages are now rising above inflation, which should benefit consumer wallets if this trend persists.

Has the outlook for interest rates really changed? At the May MPC meeting, we will have the latest BoE Quarterly Inflation Report that may provide us greater clarity on the trend for inflation and economic growth. A great degree of clarity could give them the confidence to raise interest rates. Considering the tight labour market, if rates do not rise in May it should be seen as a postponement rather than a sign that rates are not moving higher. For the economy and financial markets, the exact timing of rate moves is less important than the long-term direction of travel. Mark Carney also explained that in the longer term the biggest impact on the UK economy will come from our relationship with the EU after Brexit.  For now, we agree with the view expressed by the MPC that rate rises will be gradual and to a limited extent hence we expect one rate rise this year in May or June and another one next year.

Has the period of equity volatility passed?

This week equity markets have picked up and there seems to be less pessimism in the air.  After a period of exceptionally low volatility last year, we saw a correction in markets and a sharp rise in volatility in the first quarter. As I see it, there are two ways of looking at volatility; the first being the mathematical measure that can be derived from the options market and the second being the realised volatility from movements in actual markets. Mathematical measures mean little to the average investor but movements in the value of their portfolios are real. In last week's blog, I commented that we had seen twenty six 1% moves in the S&P Index so far this year, versus a mere seven throughout the whole of 2017. Despite the ups and downs, the US market is almost flat on the year in dollar terms. The UK market has seen fewer such movements but the FTSE 100 Index is down 5% so far this year. Volatility, as derived from options, rises when markets fall and people seek protection in the options market but if we look at actual volatility it says less about the level of the market. In comparing the UK and the US markets this year, the bigger daily moves may reflect the greater impact of Trump’s tweets in the US and the fall in the UK market may have more to do with the rise in sterling particularly against the dollar. 

As markets rise, they become more expensive and therefore more susceptible to any wavering in confidence. After such a long positive run in equity markets, we should not be surprised to see volatility rise. With Trump tweeting policy changes that often surprise even his own advisors, it is hard to see volatility being over for some time.  However, this says less about market direction as a whole and we remain broadly positive on equity markets over the longer term. Everyone may not agree with Trump's approach but his tax reform is likely to support equity markets. He may also get concessions from China on trade and even make progress in talks with North Korea. His approach, though unconventional, could result in positive news for investors. The 1% movements in the S&P 500 Index have been roughly evenly distributed between positive and negative. So we expect volatility to continue but we need to look through the noise to the longer term view. 

 

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