On the Latest BoE Hike—and Outlook

The R-word hogged headlines once again Thursday, this time in the UK. While the Bank of England (BoE) raised its benchmark interest rate again to 1.0%, the main story was its 112-page Monetary Policy Report, which contains its updated economic forecasts. Headlines will tell you the BoE is forecasting a British recession and 10% inflation, which is a rather oversimplified summary, as we will discuss. In our view, there are so many ifs in the report that, from an investing standpoint, it is almost meaningless. It will probably impact sentiment, and markets may pre-price weakening economic expectations, but we don’t view these forecasts as reason to avoid UK or global stocks.

The BoE, to its credit, doesn’t release precise quarterly GDP forecasts as if they are a fait accompli—that is the trap too many supranational forecasts fall into, in our view, pretending they can pinpoint a growth rate down to the decimal point. The BoE does release top-line forecasts like this, which is how its “forecast” for a -0.25% GDP contraction in 2023 came to dominate headlines, but that is just the central figure in a fan chart of various possible outcomes, with probabilities assigned by the BoE’s models. As a general rule, models are only as good as their inputs. The BoE’s inputs are:

• Market expectations for the BoE’s policy rate, which presently see it rising to “just over 2.5%” by mid-2023
• The Treasury’s projected spending and taxation
• Expectations for energy prices, specifically the projected retail energy price cap increase in October
• Market expectations for non-energy commodity prices

Those are all moving parts. Consider: In February’s forecasts, the BoE’s headline projection for 2023 GDP was 1.25% growth. That was based on market expectations for the Bank Rate to be at just 1.4% by mid-2023. All it took to raise the probability of a slight full-year contraction, according to the BoE’s technique, was a shift in people’s viewpoints of future rates. Those viewpoints shift regularly. What if BoE guidance and global conditions—not to mention weak economic expectations—cause market expectations to downshift again? If you are starting to suspect this is all a bit circular, you aren’t alone.

Then, too, as we mentioned, these fan charts show a wide range of outcomes. The chart showing projections for the level of quarterly real GDP, for instance (Chart 1.2 on page 14 here, if you would like to see), shows a broad distribution of potential GDP paths that could leave quarterly output anywhere from £520 billion (in constant 2019 GBP) to £630 billion by Q1 2025—the forecast’s high and low ends, with what the BoE thinks are higher-probability outcomes shaded in darker aqua colors. But, as the BoE explains:

“The distribution reflects uncertainty over the evolution of GDP growth (in Chart 1.1) and GDP (in Chart 1.2) in the future. If economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best collective judgement is that the mature estimate of GDP growth (in Chart 1.1) or GDP (in Chart 1.2) would lie within the darkest central band on only 30 of those occasions. The fan chart is constructed so that outturns are also expected to lie within each pair of the lighter aqua areas on 30 occasions. In any particular quarter of the forecast period, GDP growth or GDP is therefore expected to lie somewhere within the fan on 90 out of 100 occasions. And on the remaining 10 out of 100 occasions GDP growth or GDP can fall anywhere outside the aqua area of the fan chart.”

Translation: This forecast is full of uncertainty. It is a central bank’s detailed examination of all the potential ways its monetary policy decisions might affect economic output—an accountability tool, in theory. Stocks pre-price expected economic trends, so keeping an eye on the economic outlook is certainly useful for investors, but we are just very, very skeptical that there is anything actionable here on that front. Stocks move most on probabilities, not possibilities.

Should the UK’s economic outlook worsen to the point where it presents a material negative for stocks, we think there will be other, better ways for investors to spot it. A deeply inverted yield curve, for instance, would probably signal trouble. At Thursday’s, even with the BoE’s move, there was a 0.78 percentage point positive spread between benchmark 3-month and 10-year UK yields.^[i] That is flatter than the US yield curve, but it isn’t inverted—and it creates some wiggle room if the BoE decides to keep hiking. There is potential for the bank to overshoot—we are watching—but even then, the yield curve is a signal, not a timing tool. Other indicators to watch include the new orders components of S&P Global’s manufacturing and services purchasing managers’ indexes, which remained broadly expansionary in April.

All of which the BoE sees, by the way. The Monetary Policy Report cited today’s demand surplus as a near-term positive economic driver. The bank merely sees that demand glut morphing to a supply glut by yearend as high living costs hit households harder and higher rates squeeze businesses and lending. That is a possibility. We aren’t dismissing it. We are simply saying there isn’t a good way to ascribe actionable probabilities to this outcome for now. Not with energy prices in flux and, as yet, no hard data showing how April’s energy price cap increase and stealth tax hikes hit consumer demand.

Watching and waiting is one of the more frustrating tasks an investor can undertake, especially when sentiment is dour and stocks are in a correction. But at times like this, it is helpful to assess the situation from first principles. We don’t know precisely how the UK economy will evolve. But we do know markets are efficient and forward-looking. We know the UK’s cost-of-living pains have dominated headlines for months. Rising energy price caps have been front-of-mind since last autumn, when a shortage of wind power first sent electricity prices spiking higher. If markets are at all efficient, then stock prices must already reflect these headwinds to a great degree. Note, too, that even with all the negatives hanging over the UK economy this year, UK stocks are outperforming global markets year to date.

In our view, the question from here isn’t even necessarily whether UK GDP contracts later this year, but whether the outcome—positive or negative—is better or materially worse than what markets already priced in. If the BoE’s dismal forecast helps move sentiment even lower than it already is, then that creates positive surprise potential even if things just go less bad than feared.