FINANCIAL STIMULUS HAS MIXED IMPLICATIONS

Government spending and low interest rates have implications

  • 06 August 2020
  • 15 mins reading time
  • Governments and central banks have been quick to support an ailing global economy

  • Lower interest rates, quantitative easing and government spending have been successful to date

  • There are mixed consequences for investors

When the financial crisis struck just over a decade ago, the response from governments and central banks was slow to get going. As a result, it was a couple of years before the beneficial effects of higher government spending, low interest rates and quantitative easing (electronically “printing” new cash and injecting it into the financial system through bond-buying) were felt.

By contrast, the response this year to the throttling of economic growth because of the lockdown, has been much greater and more immediate. It appears to have been successful so far, staving off an economic depression. Instead, we are experiencing an economic suppression in which businesses and households are cutting costs and putting spending and investment on hold until the virus is permanently brought under control.

The appropriately extreme financial actions that have been taken to support households and businesses can be grouped into three categories:

  • Keeping interest rates very low

  • Quantitative easing

  • Government spending.

Each of these has consequences that are significant for us as investors. Let’s look at each in turn before we consider the overall outlook and the implications for different asset classes.

Low interest rates

Chart 1 shows how far interest rates have fallen over the past 30 years.

The purpose of this is pretty simple. When interest rates are low, it’s less costly to borrow money, enabling households and businesses to tide themselves over with loans until salaries or sales are restored. It also helps to keep existing borrowing commitments relatively cheap.

This can also support share prices as cheaper borrowing encourages spending which supports sales and company profits.

But there are other, less positive potential consequences as well.

Chart 1 - UK Base Interest Rate

This shows the interest rate that commercial banks pay to borrow from the Bank of England. Source: Schroders Personal Wealth/ Bloomberg, 4 August 2020 Past performance is not a reliable indicator of future performance.

But there are other, less positive potential consequences as well.

As we discussed in our recent article, What next for income investments?, lower interest rates lead to lower returns on savings and bonds. This has been a growing problem since the financial crisis for investors seeking steady income payments. Interest rates look set to stay very low for a good year or two, keeping interest payment and bond yields similarly low.

Quantitative easing

The situation for bonds has other influential factors complicating the outlook.

One is quantitative easing (QE) which was introduced in the aftermath of the financial crisis when interest rates were, like now, close to zero. If interest rates are pushed below zero, there are potentially disruptive consequences of paying to lend money (the effective outcome of negative rates). To avoid such an outcome, injecting new cash into the financial system was introduced to stimulate lending, borrowing and spending.

In simple terms, QE is intended to work as follows: the central bank (e.g. the Bank of England) creates new money on its electronic account (the modern-day equivalent to printing new cash); it uses this new money to buy bonds that large financial institutions hold; the financial institutions can buy more assets or use the cash to lend to customers; those customers can spend money which supports the economy.

Trillions of dollars have been pumped into the financial system through QE, creating massive extra demand for bonds which has distorted global bond prices and yields. The prices have been pushed up for bonds across all levels of risk.

Rises in the prices of bonds is further enhanced as investors become more worried about the outlook for the economy. The more worried investors are, the more money tends to be taken out of higher-risk rated assets such as company shares, and used to buy lower-risk rated assets such as Gilts (UK government bonds).

When the price of a bond rises, its yield falls and, as chart 2 shows, bond yields are at all-time lows. This has been great for investors with diversified portfolios because the bond price rises might have offset falls in prices of stocks that they held.

But it presents a challenge for the future. With bond prices so high, there is a greater potential for a fall in bond prices over the coming years as the economy recovers. As a result, we have been looking at bonds issued by stable companies with robust cash-flows and relatively low debt. Some of these bonds have a low risk-rating but offer a higher yield than is available with government bonds.

Chart 2 - Low bond yields

This chart shows the extraordinarily low yields on benchmark 10-year bonds issued by the governments of the UK, the US and Germany. Source: Schroders Personal Wealth/ Bloomberg, 5 August 2020 Past performance is not a reliable indicator of future performance.

Government spending

The previous two factors have been playing out for a decade as the financial authorities continue to grapple with the fall-out from the financial crisis. The third factor that we are considering here, played a much smaller role a decade ago but is hugely significant today; government spending.

Chancellor of the Exchequer, Rishi Sunak, had been in his post for no more than a month when he delivered a radical budget in response to the pandemic and related economic lockdown. The “whatever it takes” phrase was used and, since then, government spending on furlough schemes, NHS support, grants and loans has been unprecedented.

Mr. Sunak had been ready to pledge a fall in the total of government debt from the prevailing 79.5% of gross domestic product (GDP - the total annual output of the UK economy) to 75.2% by the end of the current government’s tenure in office.

That’s now a pipe dream. In June, UK public debt breached 100% of GDP, the first time it’s been above that threshold since 1963.

The rise in debt is being accompanied by a rise in unemployment, particularly as companies that were struggling before the lockdown find it difficult to survive. And a higher rate of unemployment means lower tax revenues for the government combined with a higher demand for welfare payments.

In short, public finances are going to be under severe pressure in the coming few years. The chances are that taxes will be raised either through new or higher taxes, or through lower allowances before taxation kicks in. Public spending is also likely to be cut as more money is needed to support increased welfare demands and higher payments on outstanding debt.

Outlook

Despite the bleak short-term outlook, we continue to anticipate a relatively swift recovery in the UK economy once the virus is brought under full control. But we expect it to be a few years before the economy fully recovers. In the meantime, we will be looking for buying opportunities not least as some companies emerge from the lockdown to a potentially less competitive environment.

The global unemployment rate was about as low as it could get at less than 5.5% coming into 2020 according to the Organisation of Economic Co-operation and Development. But the same organisation projects a rise to 11.5% this year, falling to 7.5% in late 2021. The outlook could be worse if there is a second wave of virus infections leading to another bout of lockdown restrictions.

Conclusion

In terms of investments, we remain positive on the immediate outlook for some corporate bonds as their prices have not risen as steeply as has been the case with government bonds. Over the longer term, though, bond prices could decline as the economy and investor confidence recover, reducing the demand for bonds. We will continue to include bonds in investment portfolios as we consider them to be an essential part of a diversified approach. But our preferred mix of government and corporate bonds could change as economic prospects develop.

One of the more difficult factors to foresee is politics. Governments might be tempted to reassess a broad range of revenue-generating policies. These could affect tax-free investment opportunities such as Self-Invested Pension Plans and Individual Savings Accounts and the introduction of new taxes or levies.

In short, while we continue to have confidence in our long-term outlook, we are watching for new challenges and opportunities that are likely to arise over the coming 18 months.

Important information

Any views expressed are our in-house views as at the time of publishing.

This content may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.

Fees and charges apply at Schroders Personal Wealth.

In preparing this article we have used third party sources which we believe to be true and accurate as at the date of writing. However, we can give no assurances or warranty regarding the accuracy, currency or applicability of any of the content in relation to specific situations and particular circumstances.

Forecasts of future performance are not a reliable guide to actual results in the future; neither is past performance a reliable indicator of future results. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed and the investor might not get back their initial investment,

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