BearBull Group Research: BoE to Cut Rates Slowly and Cautiously
BearBull Global Investments Group (DIFC)
BearBull Global Investments Group is a leading independent Swiss wealth advisory firm based in the DIFC
Key Points:
New UK GDP growth of +0.6%
The UK GDP growth for the second quarter mirrored the encouraging results of the first quarter. We had anticipated more positive developments and a rebound in early 2024, particularly driven by real wage growth and improved household purchasing power. This has been confirmed with both the first and second quarters of 2024 seeing a +0.6% increase. However, the third quarter is expected to be slightly less robust, with growth projected at around +0.3%. On a yearly basis, the UK GDP grew by +0.9%, a significant improvement from the -0.2% recorded in December 2023, further consolidating the UK's exit from recession, which has been modest as expected.
The UK's surprising quarterly rebound stands as one of the strongest since the end of the pandemic crisis when the government eased Covid-related restrictions. The GDP growth was largely driven by a sharp rise in government spending, up by +1.4%, while gross capital formation increased by +0.4%.
Household consumption growth was somewhat disappointing, advancing by only +0.2%, lower than expected (+0.5%). Fortunately, this was offset by higher-than-expected government spending (+0.3%), contributing to a relatively strong second quarter, though this momentum appears unlikely to continue into the summer.
Preliminary growth figures for July indicate GDP stagnation, with no growth and a slight deterioration in the three-month trend, decreasing from +0.6% to +0.5%.
Quarterly GDP growth - UK
Positive 3rd quarter driven by consumer spending
After two quarters of relatively sustained recovery, the summer is expected to be more challenging for the UK economy, despite the beginning of a monetary easing cycle that will likely be cautious and gradual. Both the production and construction sectors posted negative contributions in July, with the manufacturing sector still struggling. Manufacturing output (-0.8%) and industrial production (-1%) dropped significantly on a monthly basis, disappointing expectations after the encouraging growth seen in June. Annual figures for these sectors also declined, with construction falling by -0.4% in July and -1.6% year-over-year. The third quarter outlook remains uncertain for these sectors, relying heavily on household spending and public sector support to maintain solid growth.
The Bank of England’s first rate cut from 5.25% to 5% is expected to create better financing conditions for households and businesses, and to improve economic sentiment. On the inflation front, consumer price indices seem to be stabilizing, with the CPI at +2.2% annually and PPI at +0.2%, signaling some optimism for future monetary policy adjustments. However, it's uncertain whether consumers will quickly anticipate a significant and near-term reduction in rates and financing costs, but retail sales data from July and August already suggest a positive trend. The sharp rebound in retail sales during these two months should be enough to support GDP growth for the quarter.
The positive real wage growth is likely the main factor behind this retail recovery. We believe the prospect of further interest rate cuts by the BoE is real, supported by the decline in both consumer and producer price indices, but the central bank seems to favor a very gradual approach, which could temper consumer enthusiasm. That said, for 2024, GDP growth is expected to slightly surpass previous forecasts, reaching over +1.1%. If inflation continues to decline and the BoE decides to shift its monetary policy sooner, which seems less likely given the unchanged stance from the September 19th central bank committee meeting, domestic demand could strengthen and contribute to ongoing positive momentum.
We expect the UK economy to grow by +0.3% this quarter and finish the year with a value-added increase between 1.1% and 1.3%.
Strengthening of leading indicators
As the end of September approaches, the leading indicators published confirm expectations of a gradual economic recovery. The manufacturing PMI, although still lagging behind the other PMI indicators, has been steadily improving for nearly a year. Between June (51.4) and August (52.5), the improvement has been noticeable and suggests more favorable developments in the coming months.
PMI indicators (Manufacturing, services, construction)
On the services PMI front, despite some statistical hesitations in recent months, the overall picture remains positive, with an indicator at 53.7 still suggesting favorable and solid growth. The recent decline in the construction PMI, after six months of expansion, does not undermine the positive trend of the indicator (53.6), allowing the composite index (53.8) to point toward favorable economic development conditions. Since PMI measures do not include the public sector, we expect that increased public spending in 2024 will further strengthen positive trends anticipated for the private sector, despite a likely slowdown in its influence in the second half of the year.
Uncertain trends in the labor market
While the unemployment rate had rebounded significantly to 4.4% over a few months, likely reinforcing the BoE's view that the labor market was finally cooling enough to justify lowering interest rates, developments over the summer complicated this assessment. The unemployment rate slipped back to 4.1%, casting doubt on the actual state of the labor market. Uncertainty persists, with potentially contradictory month-to-month statistics. Job creation by the end of July, over three months, showed a tripling of new jobs at +265,000, while August's monthly change suggested a loss of 59,000 jobs. Monthly unemployment claims were also uncertain, with a revised drop of 102,000 claims for July and only 23,700 for August. The average weekly wage, excluding bonuses, declined slightly on an annual basis, but with a growth of +5.1%, household real income remains positive due to lower inflation. The potential risk of wage-driven inflation appears to be diminishing. Overall, we believe this trend should be seen by the BoE as a favorable factor, allowing it to consider a future shift in monetary policy and potential interest rate cuts.
Improvement in household confidence
The standard of living for households continues to improve thanks to real wage growth driven by the significant drop in inflation in recent months and the sustained increase in nominal wages. As a result, households can both increase their savings rate and their level of consumption. The labor market does not yet appear weak enough to cause major uncertainties, so household confidence remains relatively stable.
Household trust
Confidence has undeniably improved with the drop in inflation and is expected to be supported by the Bank of England's more accommodative monetary policy, which will broadly ease household credit conditions, reinforcing the current positive trend.
Inflation not yet fully under control
After peaking at +11.1% in October 2022, the decline of the CPI index to just +2.2% in August 2024 can clearly be seen as a success of the Bank of England's monetary policy, justifying the gradual implementation of a new accommodative monetary policy. However, the resilience of the index excluding food and energy, which has still risen by +3.6% year-on-year, and the ongoing increase in service prices of +5.6%, complicate the central bank's task. It may prefer to wait a little longer before proceeding with further cuts. While overall data points to an inflation rate close to its target, tensions remain in certain areas, maintaining some uncertainty. Regarding the rise in the services index, the +22.2% spike in airfares has been one of the main sources of pressure; this phenomenon appears to be unique and should allow the index to return to a more reasonable level in the short term. In this slightly more optimistic context, the producer price index continues to show stabilization and no longer seems to be a source of concern, having dropped from an extreme level of +20% in June 2022 to just +0.2% in August 2024.
BoE adopts a cautious rate-cutting policy
The central bank has begun its gradual easing of monetary conditions by lowering its key interest rates for the first time from 5.25% to 5%. It has decided not to initiate a new phase of easing in September, leaving that possibility open for its next meeting in November. The Bank of England (BoE) reiterated its position to adopt a gradual approach to monetary easing, emphasizing that this action is not divergent from its previous stance aimed at removing current monetary restrictions at an appropriate pace. However, the British economic situation is not particularly strong, and the risk of a setback in momentum remains significant given the relatively high level of interest rates. The BoE appears to be more concerned about price pressures in the services sector than about the risks of an economic slowdown. The labor market remains sufficiently stable, and rising real wages continue to pose an inflationary threat. We believe that the monetary policy committee will not change its policy in the short term, which will be perceived as less accommodative than that of the Fed and possibly too slow in implementing the expected normalization process, which is certainly tailored to the current situation of the British economy.
Bond market appears more attractive
The significant decrease in inflation over the past few months and the Bank of England's confirmed change in monetary policy have already altered the outlook for potential interest rate movements in the UK, as we anticipated. The opportunities mentioned for sterling-denominated bond markets during our last strategy update in June 2024 have been followed by particularly positive developments in the yields of ten-year UK Treasury bonds over the quarter. The observed decline from 4.4% to just 3.75% by mid-September still leaves considerable risk premiums in relation to the inflation level.
Given the aforementioned developments, it may take a bit longer than expected to see the key interest rates drop to 4%. However, over a horizon of a few quarters, the target level for long-term rates could be significantly lower, potentially slipping back to around 3%, if expectations of a drop in overall inflation prove accurate. The outlook is normalizing for sterling bonds, which can now hope to record notable capital gains.
Government rates (2 years — 10 years)
BoE's restraint will benefit the pound
For the past two years, the exchange rate of the pound against the dollar has remained relatively stable, fluctuating ±3% around a central value of 1.25. Recent developments in monetary policies and interest rates may now favor the British pound temporarily. The latest decision by the American central bank indicated a clearer commitment to implementing a change in monetary policy. By lowering its key interest rates by 50 basis points instead of a more gradual increment of 25 basis points, the Federal Reserve is now more proactive than the Bank of England.
We believe that the Bank of England's caution will result in a further delay in implementing its easing policy, increasing the yield differential in favor of the pound. While both institutions may have reached the peak of their restrictive policies, the momentum for normalization will likely be slower in the UK. Given this, the GBP/USD exchange rate could eventually break out of its current stabilization zone between 1.25 and 1.30 against the US dollar to reach 1.35.
Regarding the pound/Swiss franc exchange rate, the situation is slightly different, particularly due to the significant differential that will persist even during a phase of rate cuts in both the UK and Switzerland. The weakness of the Swiss franc will likely manifest against the pound as well, which we expect to appreciate. The stabilization of the exchange rate within a fluctuation band between 1.10 and 1.15 since November 2022 could therefore be tested by an increase beyond 1.15–1.17 in the coming months.
Effective exchange rates of the Pound
Moderate short-term attractiveness of securitized real estate
The monthly evolution of physical real estate prices in the UK proved positive in September (+0.8%), pushing the year-on-year increase to +1.2%. After surpassing +10% year-on-year in July 2022, property price growth contracted for about six months before resuming a slight upward trend since March 2024. According to UK Rightmove data, real estate prices are again on the rise despite still relatively high interest rates. More favorable prospects for upcoming financing costs contribute to a revival in demand. Mortgage approvals have also shown significant progress since the beginning of the year, remaining high at around 60,000 approvals per month for the past six months.
We estimate that the real estate market will remain in a consolidation and stabilization phase in 2024, with no major short-term price increase opportunities. Regarding securitized real estate, its short-term evolution is more correlated with inflation and interest rates than with the physical market. Following a downturn of -34% in 2022 and -17% in 2023 due to negative expectations linked to rising financing costs, which collectively brought the correction of listed property prices to nearly -50%, British securitized real estate now appears particularly interesting again.
After a long consolidation period of over 20 months, securitized real estate has been rising since the end of February, but it seems to await a more decisive change in monetary policy for more significant progress. The performance of the EPRA Nareit UK index in 2024 has remained volatile and hesitant, still marked by the negative effects of a potential recession on prices and rental incomes. The price/net asset value ratio of 83% is not particularly attractive, although it is lower than the ratio observed in the United States, but the yield of 4.84% could soon appear very appealing in a declining interest rate phase.
We believe the next phase of interest rate adjustments will occur in the coming months, allowing for a 100 basis point reduction in financing costs for REITs. In this more positive context for securitized real estate, attractive yields and capital appreciation prospects should support investor interest.
FTSE100 lacks catalyst for further growth
The FTSE 100 index has significantly underperformed compared to other European and international indices for several quarters. It continues to suffer from negative expectations linked to a sluggish economic environment, overly cautious monetary policy, and competition from the domestic bond market. The stabilization of the index above 8,200 points should persist in the absence of a catalyst for further growth.
The index's composition, which is very little exposed to growth and technology stocks, partly explains its underperformance in 2023 and the first half of 2024. The current level of the equity market offers some opportunities due to relatively attractive valuation measures, both on an absolute and relative basis. Overall, FTSE 100 companies continue to benefit from a relative advantage with an average price-to-earnings (PE) ratio of 12.3x, although this is only marginally lower than the PE of European stocks (13.8x).
The UK market is not particularly appealing, but it should still be supported by anticipated interest rate cuts in 2024.
UK equities and real estate securitizes