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Idea of The Week: What Does The Bank of England Rate Hike Tells Us [10 November 2017] November 10, 2017
In this idea of the week, we will take a look on the fundamentals as well as the recent developments in UK economy and discuss some of the key takeaways in light of the recent rate hike event.
Author : iFAST Research Team


Idea of The Week: What Does The Bank of England Rate Hike Tells Us [10 November 2017]

In its latest monetary policy meeting, the majority Bank of England’s (BOE) Monetary Policy Committee voted to raise its benchmark interest rate from 0.25% to 0.50%, reversing a rate cut made in August 2016 in conjunction with the Brexit referendum in order to spur economy growth. It is the first rate hike we see in UK in a decade, since the Global Financial Crisis (GFC) struck the global economy and tipped the UK economy into recession.

In this idea of the week, we will take a look on the fundamentals as well as the recent developments in UK economy and discuss some of the key takeaways in light of the recent rate hike event.

How is the UK Economy doing so far?

The British economy grew 0.4% quarter-on-quarter in 3Q 2017, an increase on the quarterly GDP growth of 0.3% recorded in the first two quarters of 2017. The service sector, one of the dominant growth thrust of the UK economy grew by 0.4% in third quarter of 2017. Manufacturing also boosted the economy with an improved performance, growing 1.0% during the quarter while construction sector suffered its second quarterly contraction in a row (see Figure 1). Even though the UK economic has improved on a quarterly basis, however UK economy growth is still rather disappointing as their annual economic growth is only at 1.5% in the latest quarter, slower than the 1.9% growth in the quarter before the Brexit referendum in June 2016 (see Figure 2).

FIGURE 1: Stronger service sector attribute to the latest economy growth

FIGURE 2: UK economic growth is benign

Looking at the wage growth, the British economy has been struggling to generate wage growth where its 3-month average wage growth is at 2.2% on yearly basis is still lagging far behind from the 3% inflation rate (refer to Figure 3 and Figure 4). It is painting a disappointing picture for the UK economy where the impact of rising inflation and sluggish wage growth will further suppress consumer’s spending power in the near-term.

FIGURE 3: Stagnant wage growth

FIGURE 4: CPI above BOE's inflation target

Why raise the interest rate now?

In most cases, the central bank would raise interest rates when the economy begins to overheat, that is when consumer and business demand is accelerating. Looking at UK economy today, one would hardly conclude that the economy was overheating.

So why did the Bank of England raise the interest rate? One of the reason the central bank raised their interest rate is that the inflation rate in UK has been above the BOE’s target inflation rate of 2% this year (see Figure 3). The higher inflation in UK was mainly attributed to the depreciation of the pound that has occurred since the Brexit referendum. With that, the central bank will need to raise its interest rate in order to curb its high inflation rate.

In addition, raising interest rates tend to give the bank more bullets to cut again if it needs to. As rates are already at or near record low, the possibility and ability for the bank to cut further will be limited. We think that the BOE is being mindful in managing the risk of hard Brexit as uncertainty over UK’s future trading relationships, regulations and migration policy have led many firms to put their investments on hold.

FIGURE 5: First rate hike in a decade

Takeaway

All in all, the uncertainties associated with Brexit are weighing on the UK economic activity. The increase in interest is not a sign of the UK economy is overheating, but it is a necessary measure for the Bank of England to combat with the rising prices. Given that the UK economy is consumption driven, we perceived that the increase in interest rate will hurt the consumer’s spending ability and weigh on the economy as the consumer might suffer higher borrowing cost despite the central bank move is to curb the high inflation. However, if the central bank does not act on the high inflation by raising interest rate now, the inflation rate might go even higher and eventually be detrimental to the consumer sector.

Given that we are neutral on the UK economy, we suggest investors who are seeking for higher upside potential can look into our favoured Asia ex-Japan or emerging market region as valuations remains to be supported by robust earnings growth as well as the encouraging economic backdrop in the near-term.

Read FSM Fund Choice: Eastspring Investments Global Emerging Markets Fund [November 2017]


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