Mott reacts to rate cut decision
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If the Smiths were to accept this offer, they would be signing up to increased monthly mortgage payments and it would further constrain their spending for each month with the additional burden already in place of higher fuel bills and food costs spiralling. At this point, the Smiths have little choice so they choose to shop around for a new mortgage. Wherever they go, they are greeted with huge arrangement fees and generally higher rates than they had previously. Having finally established a new mortgage from somewhere, they sit down as a family and review their monthly finances.
Things have to change and 'belt tightening' is the new family way. Out go the mid-week visit to the Chinese restaurant, out goes the visit to Waitrose to be replaced with new shopping at Aldi and Lidl. The second family holiday is now doubtful and the kids are told to ease up on mobile phone bills and they decide to renew their car in two years' time rather than this year.
After last week’s news, the Smiths sit down again to review their finances and find that they are going to be £80 a month better off on their mortgage as a result. The key to the U.K. economy is encapsulated in what the Smiths do next. Which of the following scenarios best describes the Smiths likely behaviour?:
1) Scenario 1: They breathe a sigh of relief and revert to their old habits, spending the full £80 a month and regard the last few months as uncomfortable, but now over. They go back to Waitrose and start living the life they led before.
2) Scenario 2: They have been troubled by the last year and decide to bring a degree of caution to their lives. They decide to spend £40 of the £80 and decide to go out for a Chinese meal every two weeks and reinstate their second holiday but decide on a U.K. cottage rather than the Maldives or Lanzarote. They put the extra £40 into a savings account and pay off their credit card bills on time just in case this financial firestorm happens again.
3) Scenario 3: The Smiths are so scarred by the fright they have had over the last few months that their collective view is 'never again'. ‘We have learned our lesson', they say. They put the entire £80 aside each month to pay off their credit card bills and to build up their savings. It will be some years yet before they revert to their more carefree lifestyle.
In these three possible outcomes rests the future direction of the U.K. economy. If you multiply the Smiths by millions of other families in the same position, the outcomes are as follows:
1) Scenario 1: The economy revives quickly. Domestic cyclicals such as retailers, pub operators, house builders and property companies revive quickly and disaster has been averted. A short term fix has been applied but the long-term rebalancing of the UK economy to suppress over-consumption and stimulate production has still to occur. It’s a ‘quick fix’ but Armageddon has been avoided. Long-term imbalances still need to be tackled
2) Scenario 2: An anaemic recovery is underway. This avoids the worst of recession but growth is muted and weak but enough to keep the stock market up above its lows. This is the preferred solution because it allows long-term rebalancing to occur without a precipitous collapse in consumption.
3) Scenario 3: We have a Japan-style deflation/slump. However much money the Government throw at the Smiths through tax cuts and interest rate cuts, the Smiths and others are on a 'spenders' strike'.. The rebalancing of the UK economy will then have to occur through a horrendous consumption slump. The UK would suffer a massive recession.
Last Week’s 1.5% UK Interest Rate Cut
Last week’s dramatic announcement of the biggest surprise one-day interest rate move for a generation is an indication of capitulation at the Monetary Policy Committee (MPC). It’s hard to imagine how this group meeting must have been when the outcome is so dramatic. What we do know is that Professor David Blanchflower has been vindicated totally and the capitulation of some other group members to his view of the economy is something of a humiliation for them.
To recap, Professor Blanchflower’s view since early this year has been that UK inflation was been driven by external world factors (oil, wheat, food generally) and not by UK generated factors. He urged for UK rates to be cut decisively and quickly because of his concerns that the UK was heading towards recession and a dramatic slowdown. We have agreed with this view all year and we were surprised and disappointed that UK interest rates were not cut when they should have been.
Just six weeks or so ago, Chairman of the MPC, Mervyn King’s comments were all about inflation. All of a sudden, in his Leeds speech, the word ‘recession’ suddenly appeared as his key message. But, painfully for the UK economy and the stock market, he had been looking through the ‘rear view mirror’ at ‘yesterday’s story’ and ‘playing the wrong game’. This must be one of the fastest journeys from ‘inflation’ to ‘recession’ in economic history. In our opinion, the credibility of many MPC members has been shredded by this issue. Unlike the US, who cut rates early to get ‘ahead of the curve’, there is a serious risk now that this action could be too late and that UK rates will need to go even lower to avoid a huge slowdown. This should have been avoided and serious policy errors have been made.
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Giving that elastic one almighty tug……. ‘Pulling on a brick with a piece of elastic’
So where are we now?
In my previous note, I used the analogy of a brick being pulled by a piece of elastic. Just to recap…
I would liken the current economic situation to trying to pull a brick with a piece of elastic. There are three ways that pulling on a brick with elastic can unfold:
1. You pull on the elastic a number of times and nothing happens. Eventually, as you pull the brick even harder, the elastic snaps and the brick remains stationary. You have used up all your ammunition (rate cuts). The economy is mired in recession and we are in the Smiths Scenario 3 above occurs.
2. The brick starts to move proportionately in line with the interest rate cutting force applied. Each gentle tug (interest rate cuts) sees the brick gradually moving along in a careful and controlled way and we have the 'perfect world' where economic stimulus creates a mirror response in the economy. This is scenario 2 in the Smiths' story above and the best possible outcome.
3. After multiple tugs, the brick moves suddenly and hits you in the face. Potentially, this could happen in Smith Scenario 1 above, as bad habits re-establish themselves and the consumer believes that he has been ‘let off the hook’ from past excesses.
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We at PSigma remain of the view that Scenario 2 for the Smiths is the more likely outcome, in which case, equities should begin to perform much better as we move into 2009.
Whether last week’s significant pull on the elastic (1.5% interest rate cut) starts to move the brick is uncertain but, if it doesn’t, further tugs on the elastic (more interest rate cuts) should start to get the brick moving.
We have got our eyes on firmly on the elastic and the brick.
