Central bank watching can be like bird watching in more than one way. Firstly, it generally comes down to identifying one type of bird from another – like a dove from a hawk. Secondly, it is rather dull most of the time, but once in a while it can be really exciting.
With UK inflation above the 3% upper target range for 40 months, many investors have been looking for signals from Threadneedle Street to determine how monetary policy makers will address rising consumer prices and the impact their decision will have on money markets’ liquidity.
The Central Bank Dilemma
Central banks from Washington DC to Beijing find themselves in something of a trap at the moment as increasing interest rates from their record low levels could have the desired effect of slowing down inflation, but it could also slow down economic growth. In addition, with inflation-targeting a prime central bank objective, particularly in the UK, the mere consideration of other objectives, such as economic growth, eats into the credibility of the Bank’s independence.
Crucially, central bankers disagree on the strength of the relationship between prices and interest rates spelled out above, the extent to which inflation is currently a problem in developed markets, and the degree to which domestic inflation is driven by the local lending rates and not by import prices and currency dynamics. Hence the split between doves and hawks among monetary policy makers.
As inflation worries take their toll on consumer minds, the split between the pro and con rate hike camps deepens, as we saw in the minutes of the Bank of England’s Monetary Policy Committee meeting released this Wednesday. In the latest MPC meeting committee member Martin Weale joined Andrew Sentance and Spencer Dale in calling for monetary policy tightening.
Is Past Performance Indicative of Future Performance?
Interestingly, based on their past votes, Weale, Sentance and Dale would all be categorised as inflation hawks. This is based on the premise that past behaviour is indicative of policy makers’ views on economic fundamentals and their positioning in the dove-hawk scale is unlikely to oscillate in the short term. This premise doesn’t always hold true, however.
As a recent BofA Merrill Lynch research report points out, “voting patterns are only of limited use when balancing a likelihood of change.” Statesmen, Mervyn King for example, will change their stance depending on the economic background. Committee members will also enter the MPC at different times of the cycle and not have a track record long enough to make conclusions. In the current MPC make-up, only King, Charles Bean, Paul Tucker and Sentance have served long enough that their voting history is relevant.
With these words of caution in mind, listed here are the current members of the Bank of England’s Monetary Policy Committee and their positioning on the dove-hawk axis.
A Shelter from the Birds
In theory, says Brook Sweeney, Consultant with Morningstar Associates Europe, the economic environment should have been taken into consideration when strategic portfolio allocation calls were initially made. That said, the inflation expectations in the UK have substantially changed in the past eight to twelve months and we are now looking at an inflationary environment, whereas a year ago we were worried about deflation. Most arguments are in favour of higher prices being a sustained trend, rather than a blip, and therefore a valid consideration when thinking about portfolio restructuring.
How one factors higher prices and potentially higher interest rates into their holdings is highly dependent on one’s investment objectives. An investor looking for income in the next year is unlikely to find it in cash and government bonds, for example. Equities, however, look more attractive at the moment. They are relatively cheap and stable cash-generative multinationals, such as AstraZeneca, GlaxoSmithKline and Vodafone, are attractive from a yield perspective, Sweeney says. In general, in an inflationary environment equities are a better place to be than government or corporate bonds as inflation eats away at the real yield on bonds, whereas equities are likely to grow in value as companies are able to pass on the cost of inflation to customers.
In addition, investors can seek inflation protection from inflation-linked government bonds and commodities. The former are highly priced at the moment, which is not unusual given the current environment. “The last time inflation-linked gilts were not expensive,” explains Sweeney, “was in the midst of the crisis when the UK was facing deflation.” For this reason, Sweeney wouldn’t recommend piling in on them.
Commodities are a straightforward anti-inflation game as they stand to appreciate as inflation accelerates. However the game strategy one would pick when approaching the commodity sector, be it through listed commodity companies, ETFs or physical purchases, has its own traps to avoid. For example, commodity companies have already seen their share prices increase markedly as the global economy recovers and some could now be considered expensive from a valuation perspective, Sweeney points out. In terms of ETF investing, read this article about the intricacies of commodity ETFs.
If interest rates are increased, as many believe they will be, the move would in theory curb borrowing and ultimately slow down economic growth. Therefore cyclical equities such as financials, auto manufacturers and real estate stand to lose out. This argument, however, has more gravity when the economic cycle is at its peak. In the current environment, interest rates rising would instead signal that growth is strengthening and can afford the impact of higher cost of corporate borrowing as well as a potential increase in individual saving rather than expenditure.
A more straightforward argument about the portfolio implications of a rate hike exists in the fixed income space. As bond prices and interest rates are inversely related, long-duration bonds will be relatively more impacted by an interest rate increase than short-duration bonds since the former will exist in the post-rate-hike environment for longer than the latter. This logic generally applies to both government and corporate debt.
A key takeaway would be that dissenting opinions and macroeconomic pressures induce market uncertainty and volatility. Trying to capture market momentum in this environment might be a particularly difficult task and therefore rash portfolio reallocations may turn out to be unwise. At the same time, it is worth remembering that where one company is domiciled is not necessarily reflective of where its revenue is generated, and more likely than not your large-cap UK portfolio is more influenced by Chinese rate hikes than Bank of England decisions.
