Interest Rates Held Steady
Last Thursday, the Bank of England decided to maintain the interest rate at the current level of 5.25%. Two of the nine Monetary Policy Committee members voted for an immediate rate cut (only one was expected), while the Bank’s governor, Andrew Bailey, strongly suggested a cut will come in the next few months, assuming inflation continues to fall as they expect it to do so.
Having an Impact
Interest rates have been high in order to suppress inflation and the Bank believes this has been having an impact, stating “The restrictive stance of monetary policy is weighing on activity in the real economy, is leading to a looser labour market and is bearing down on inflationary pressures. Key indicators of inflation persistence are moderating broadly as expected, although they remain elevated”. While this outlook is promising, the second sentence in this quote highlights the challenge the economy faces on its path towards lower interest rates.
On the Right Path
Headline CPI, the most widely viewed measure of UK inflation, has fallen to 3.2%, and inflation in goods has fallen to just 0.8%, but inflation in services (which includes labour costs) remains elevated, at 6.0%. This figure has decreased from the previous month and the Bank takes comfort that this is a sign the recent spike in wage growth is fading, something which is seen as a prerequisite for headline inflation to come towards 2% on a sustainable basis. The bank therefore believes it is on the right path with its primary objective of ensuring price stability.
End of the Recession
What’s also good news, in the eyes of the Bank, is the level of economic growth. After two quarters of contraction in the second half of 2023, the UK was technically in a recession. However, following positive growth reports for January and February, the Bank was confident the data for March would also be positive, predicting a return to growth for the overall quarter. The Bank didn’t have to wait long to see if their prediction was correct. The Office for the National Statistics released the official data the following day, confirming that the UK had exited the recession, with a surprisingly strong reading of 0.6% for Q1 (the Bank of England had forecast a figure of 0.4%). In commenting on the improved condition of the national finances the Monetary Policy Committee said they “expected the recovery in output to be underpinned by a pickup in household consumption, supported by higher real incomes”. In other words with inflation falling and wage growth still high, the average consumer was in a better position than last year, allowing household spending to increase.
Easing Conditions for UK and Europe
A positive two days for UK watchers then, with growing confidence that interest rates are nearing a reduction, while signs of significant improvement for the domestic economy. Those focused on European markets are also likely to experience improving conditions, as the European Central Bank similarly signalled that a cut to interest rates could come as soon as June.
US Divergence
Looking across the Atlantic, conditions appear to be diverging. Inflation is falling in the UK and Europe, yet over the past few months, the level of price rises has started to accelerate again in the US. Here, the US appears to be a victim of its own success, with a surprisingly strong economy that has shrugged off elevated interest rates in place over the last two years. This situation leads to a different calculation for the US Federal Reserve. At the start of this year, investment markets were expecting the Fed to cut interest rates six times through the course of 2024. However, currently that expectation has fallen to one or two rate cuts by year-end. In terms of the number of cuts, this isn’t much different from the position in the UK, with traders expect two cuts this year, but the expected timing of those cuts in the US is getting pushed back, while in the UK they are more stable.
A Broadening of Markets
This suggests that while the US economy is strong relative to the UK and Europe, with inflation posing more of a problem for the former, conditions are likely to improve on a relative basis for the UK and our continental neighbours over the coming months, which is important to investment markets. 2024 started with US dominance, driven by optimism related to AI and the rise of the ‘Magnificent 7’ grouping of US stocks expected to benefit from technological advances. As the year has progressed and economic news improved, the market has broadened out. Non-AI stocks have clawed back lost ground within the US, and internationally, European, UK, and Asia equity indices have also improved relative to the US.
Economic Support for Markets
What the rest of the year brings for markets is of course uncertain, with geopolitical issues always a potential source of instability. However, from an economic perspective, conditions are improving and those areas which experience interest rate cuts are likely to be rewarded by investors. Attractively valued equities appear the most likely beneficiaries, but bond markets too could prove fruitful. So far in 2024, fixed income sectors have seen flat performances, as concerns over the persistence of high interest rates have tempered expectations. Yet, if rate cuts are delivered, their prospects will likely improve.