Economic Update: 15 September 2017

Economic Update: 15 September 2017

The Investment Management team round-up some of this week’s news.

Doves And Hawks

UK inflation figures released by the Office for National Statistics are at their highest level for over 3 years. Prices increased 2.9% over the year to the end of August, marginally ahead of the forecast figure of 2.8%.

Price growth in goods outpaced services (3.1% v 2.7%) with liquid fuels, which includes petrol, rising 17% over the year. While inflation is affected by a number of different factors it looks likely that the drop in the value of the pound is pushing prices up in some areas: sterling has depreciated by 13.1% against a basket of major world currencies since the Brexit referendum last June

GBP/USD Exchange Rate

Source: Bloomberg. Data as of 14/09/2017

The Bank of England (BoE) has employed a combination of low interest rates and an extensive Quantitative Easing programme to boost consumption. This is accompanied by an explicit inflation target of 2%. UK inflation has been above the BoE’s current target of 2% for the last 7 months, putting pressure on the Monetary Policy Committee (MPC) to decide whether markets can withstand a rise in interest rates, something which we haven’t seen since July 2007.

At this month’s meeting, two out of the nine MPC members had a hawkish, stance in favour of putting up interest rates. The hawks believe the economic outlook is sufficiently stable to allow interest rates to rise gradually. Paraphrasing the MPC, if the economy continues to be resilient and there are clear signs of wage growth building, then an increase in interest rates could come earlier than expected. They went further by adding, that this could take place possibly as soon as the next meeting in November alongside the inflation report. The MPC is also now forecasting inflation to exceed 3% in October saying signs of wage growth are more evident with unemployment in the UK falling to 4.3% – the lowest level in 42 years. Falling unemployment tends to push wages higher, however, so far in this cycle wage growth has remained relatively muted. This is one of the issues perplexing central bankers. Some believe downward pressure on wages is structural while others think that it is only a matter of time before wages move upwards as any residual slackness gets pushed out of the labour market.

UK Unemployment Rate

Source: Office for National Statistics. Data as of 31/07/2017

A decision to raise interest rates tends to strengthen an economy’s currency (at least in the short-term) and with the BoE giving stronger signals around rate hikes, sterling increased 0.8% against the US dollar and 0.75% against the euro in the first 20 minutes after the announcement. Sterling ended the trading session at $1.33 and €1.12 respectively.

Despite the doves having a clear majority favouring keeping rates on hold at this week’s meeting, MPC members made some hawkish comments suggesting we could see potential hikes in the upcoming months. Rate rises may begin with the BoE reversing the cut to quarter point interest rates made in the aftermath of the Brexit vote. This cut is now generally considered to have been unnecessary. Moreover, rate rises are a sign of economic rehabilitation after years of emergency measures.

The probability of a rate rise this year has risen to 63.4% compared with 41.9% the day before the meeting.

Bank of England Interest Rate Hike Probability

Source: Bloomberg. Data as of 15/09/2017

Renewable Energy Boost

The economic case for renewable energy is being strengthened by falling costs. The latest round of auctions for selling offshore wind saw prices falling well below the price guaranteed for electricity from the planned Hinkley Point C nuclear plant.

The announcement takes offshore wind one step closer to grid parity (when an alternative energy source can generate power at a cost which is equal to the price of purchasing power from the electricity grid). Improvements in technology, supply chains and cost of capital are allowing less reliance on subsidies and government support mechanisms.

The need to subsidise the transition to a more favourable source of energy is appropriate especially when the subsidy is relatively small in relation to the impact lower electricity supply costs have on economic competitiveness. High energy costs encourage businesses to re-locate operations to jurisdictions where costs are lower and keeping the lights on is critical to businesses and households. Therefore, it seems likely that governments will continue to offer incentives and subsidies to those willing to produce and supply renewable energy in a way that will help reduce costs for the end users.

Transitioning towards a sustainable energy producing economy can encourage job creation, energy efficiency, better transportation links, waste reduction, natural resources conservation and even facilitate education. Furthermore, employment through installation, maintenance and construction tends to happen within the country of origin giving a boost to growth and spending.

UK Electricty Generation Costs

Source: Bloomberg. Data as of September 2017

The new £57.50 MWh tenders for offshore wind are roughly level with natural gas plants in the UK even at today’s low price for gas. With technology improving, it is likely that costs have the potential to fall further. For the UK, the potential is vast relative to other European countries which are either landlocked or partially landlocked. Not only does the UK have the potential to produce low-cost renewable energy and attract businesses with high energy demand, the UK has the opportunity to turn into a giant wind hub, propelling the country into one of the leading global energy exporters.

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