Interest rates: steady as she goes

Posted by Liz Rees in Latest insights category on 09 Aug 18

Last week brought important news for savers and investors. The UK base rate was raised for only the second time in a decade, taking it above 0.5% for the first time since 2009. Moreover, the latest data on dividends revealed healthy pay-outs from the corporate sector and a positive outlook.

After several months of ‘will he-won’t he’ speculation, Bank of England Governor Mark Carney announced a quarter-point increase to 0.75%. While the move was expected, the unanimous vote from the nine Monetary Policy Committee (MPC) members was a surprise. Only last month the split was 6-3 in favour of leaving rates on hold. However, Mr Carney emphasised that further increases will be gradual and limited; with perhaps three hikes in three years on the cards.

The increase had been deferred due to disappointing economic data for first quarter of the year, so the catalyst for the change in stance is likely to have been a marked pick-up in services and construction activity, while retail sales have also improved. The MPC expects a recovery in Q2 and Q3 to produce GDP growth of 1.4% this year, followed by 1.8% in 2019.

In truth, current consensus growth estimates of 1.5% for the full year are not exactly synonymous with an economy on steroids, so what else spurred the MPC to take action? Well, the other main drivers for putting up rates are usually a need to dampen inflation or to support the currency. Of course, these are to some extent inter-related; continued weakness in the Pound pushes up the cost of imported goods which leads to higher inflation.

Certainly, sterling has suffered a renewed bout of weakness, not helped by UK trade secretary Liam Fox suggesting the odds of a no-deal Brexit stand at 60:40 on. Furthermore, a clear message in the Governor’s speech was the need to contain inflation close to the Central Bank target of 2%. Despite weaker than expected Consumer Price Index (CPI) inflation in June, leaving it at 2.4% for the 3rd month in a row, the MPC noted it would remain above target as the Pound’s weakness and a higher oil price feed through. It also drew attention to the ’very limited degree’ of slack in the economy, and unemployment at a 42 year low, leading to growth in real wages.

Another reason hinted at was the desire to dampen household’s propensity to borrow; consumer indebtedness remains a worry and is being closely monitored. Recent figures from the Office for National Statistics revealed that consumer borrowing is still expanding and, in 2017, consumers spent more than they earned for the first time in 30 years.

The Bank also introduced a new statistical pointer, R*or the ‘equilibrium real rate of interest’, which takes account of various forces acting on the economy. In essence, this is the long-term interest rate at which the UK can grow sustainably, with full employment and ‘near target’ inflation. It is calculated to be 2-3% nominal, compared with closer to 5% before the financial crisis. However, in the short-term it will be depressed by factors such as weak productivity, demographic trends and deleveraging.

So, caution seems to be the order of the day with clouds on the horizon mentioned, including Brexit uncertainty and threatened trade wars. As I’ve said before, if we don’t get away from these rock bottom rates, there will be less scope to give the economy a helping hand in the event of a no-deal Brexit or when the next, inevitable recession arises.

The stock market is likely to be satisfied with this slow move towards normalisation of monetary policy from the emergency levels following the financial crisis. A similar path adopted by the US Federal Reserve, which is further along the tightening curve, has not prevented a strong performance by equities, albeit with a boost from fiscal stimulus.

Turning to the news on UK dividends, the latest data implies that investors seeking equity income are well placed to benefit from substantial and growing pay-outs. Link Asset Services, which monitors dividends, reported that UK companies paid out a record £30.7bn in regular dividends to their shareholders in the second quarter of 2018. Excluding specials, this was 7.1% higher than last year and Link expects underlying growth of 6.9% this year taking the total for the year to £94.1bn.

What’s encouraging is the strong cash generation from the corporate sector, improving dividend cover by earnings. Admittedly, some of this will be down to cyclical recovery, for example in the mining sector, so it remains important to identify companies which can produce a reliable stream of income through the economic cycle. Smaller companies and growth stocks may yield less but have more potential to grow their dividends at a higher rate, in line with their earnings. The corporate sector is generally in a healthy financial position with strong cash-flows allowing debt to be paid down and the option to increase the proportion of equity financing.

So, what does all this mean for our finances? Certainly, it should help hard-pressed savers, yet whether savings accounts see the full benefit, time will tell. Banks were slow to pass on the previous increase, if at all. Also, some accounts may have a fixed rate or an elevated introductory rate so won’t see any change. On the other side of the coin, retail borrowers will obviously feel some pain but a significant proportion of mortgages are fixed so the impact will at least be deferred. Again, we should remember that the current rate is still extremely modest by historic standards.

In conclusion, it’s probably not the time to be jumping ship from equities to cash-based products while real returns on cash remain in negative territory. I would also be a little wary of adding to government bonds until their yields reach a more tempting level, although their role as a diversifier in portfolios remains intact. Some corporate bonds still offer attractive yields, corresponding to their level of risk.

To illustrate the current divergence; the FTSE 100 yield was 3.8% at the end of July, a 10-year Gilt provides a fixed income of 1.3% and the best easy-access cash deposit around 1.4%. So, with the pre-crisis yields of 5% on gilts and cash unlikely to return anytime soon, the current environment of relatively low interest rates seems set to remain supportive for equities.