The good and the bad from the BOE

There was plenty to cheer about for the UK economy today. The service sector PMI for April beat expectations and rose at its fastest pace for more than 7 years, rising from 56.3 to 61, a sign that the end of lockdowns has led to a surge of pent-up demand surging through the UK economy. New order volumes, a key lead indicator in the service sector PMI, rose at its fastest pace since 2013 and confidence in future activity is also rising, with 65% of respondents confident about the outlook for the future, only 7% were not confident. Employment was also higher, which has eased fears that the end of the government’s furlough scheme later this year will not lead to a spike in unemployment. The concerning aspect of the PMI report for April was inflation, which suggests that price pressures are rising at their fastest pace for four years in the service sector including for transport costs, staff costs and higher import costs for raw materials. There are also signs that service businesses are hiking prices for the consumer. With clear evidence that inflation pressures are rising in the largest sector of the UK economy, why was the Bank of England so sanguine about inflation?

Inflation: tomorrow’s problem 

The second Bank of England Monetary Policy Report was released today, and it generally delivered a feel-good message. The mixture of easing lockdowns, a fast and effective vaccine rollout combined with businesses adapting well to new conditions has boosted the BOE’s growth expectations for this year from 5% to 7.25%, the fastest annual rate for 80 years. The good news is that 2020’s dramatic decline in UK output is now expected to be fully revered by the final quarter of 2021, sooner than many anticipated a few months’ ago. The consumer is the chief driver of growth, with a boom in consumption expected in the coming months as lockdowns continue to be eased. Investment is another driver of growth, the UK is sitting on £150bn of covid savings, with 10% of this expected to be spent over the coming three years’, the BOE had previously only expected 5% to be spent, as fears about lingering unemployment led to consumers remaining cautious. However, the BOE is now expecting caution to be thrown to the wind, as it revised down its forecast for peak unemployment to be 5.5% for the second half of this year, down from 7.75% in February. Household spending is expected to rise by a robust 5.35% this year, and business investment is expected to be a stellar 7%. These are a good set of numbers, however, they did not benefit the pound, which was down a touch and is currently trading back below $1.39 versus the US dollar, after treading water for most of this week. The FTSE 100 was higher on Thursday and is back above 7,000. 

What the better UK outlook means for stocks 

The news from the BOE is undoubtedly beneficial for the UK stock index, which is heavily linked to economic performance. The best performers on the FTSE 100 today were materials and energy companies, with Fresnillo up more than 6% as precious metals continue to rise. Next was also a top performer, after it reported strong results particularly online, it should also benefit from the consumer spending boom in the coming months. The bond market had an interesting reaction to today’s MPC report. Some may have expected UK Gilt yields to rise on the back of the BOE upgrades, however, that did not happen. Gilt yields, along with Treasury yields in the US have drifted lower this week. The 10-year Gilt yield is below 0.8%, and the 10-year Treasury yield is trading around 1.56%. So why, when there are so many red flags, are central banks not worried about inflation? 

Global central banks remain in wait and see mode 

Bank of England governor, Andrew Bailey, said that he expects inflation to be temporary, which is similar to the message on inflation expressed by the Federal Reserve in the US. The BOE also said that it would wait to see if inflation was permanently above the BOE’s target rate of 2% before it would tighten policy. However, the Bank will slow its pace of asset purchases this year to ensure that it reaches its target of £150bn, it had bought £67bn by the end of April. The BOE argues that slowing or increasing the pace of purchases is an operational matter, and not a sign of a shift in policy, which is why the bond market did not react to this news. 

Overall, the BOE is towing the global line on sanguine inflation pressures, and it seems like the world’s major central banks are not willing to tighten policy any time soon. Thus, it remains extremely unlikely that interest rates will rise in 2021, however, if inflation continues to rise for the long term, and if we can avoid another wave of Covid infections this winter, then central banks may need to consider raising interest rates and tightening policy towards the start of 2022. For now, this is a problem for another day, and inflation sensitive assets remain muted. This is causing ripples in other markets including an uptick in the gold price, which is a traditional inflation hedge and could also be a considered a hedge against the possibility of central bank mistakes. Earlier this week, crypto currencies had also surged, and many cryptos remain close to record highs as central banks continue to pursue expansionary monetary policies. However, some cryptos, including bitcoin and dogecoin (a relative newcomer in the crypto market that has dubious backing), were falling as we move into the end of the week, and we could see further profit taking on Friday. However, we believe that any downside could be bought in to. 

Geopolitical concerns close to home 

Right now, the escalation in tensions between the French and the British on the island of Jersey has not had an impact on GBP markets. Fishing, yet again, is the main point of contention between the two sides. However, if tensions escalate over the weekend then it could trigger a wave of selling in the pound, so watch out for geopolitical headlines close to our shores.