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The Bank of Eeyore Grumbles the Truth. Who’s Next?

The Bank at Pooh Corner

One of Britain’s most memorable characters is Eeyore, the perpetually melancholy donkey from A.A. Milne’s stories of Winnie the Pooh. Sitting on his own at his house on Pooh corner, his attitude more or less condemned him to continued misery. Perhaps the Bank of England’s governor, Andrew Bailey, missed an opportunity when he didn’t channel his inner Eeyore to greet journalists at his press conference with a cheery: “Good morning. If it is a good morning. Which I doubt.”

It’s hard not to think of Eeyore when reading the commentary that the Bank published Thursday, in conjunction with the announcement that it would be raising rates by 50 basis points, the biggest increase since 1995 (and the biggest ever since the BoE gained its independence under Tony Blair and Gordon Brown in 1997). This is what it had to say about future prospects:

Inflationary pressures in the United Kingdom and the rest of Europe have intensified significantly since the May Monetary Policy Report and the MPC’s previous meeting. That largely reflects a near doubling in wholesale gas prices since May, owing to Russia’s restriction of gas supplies to Europe and the risk of further curbs. As this feeds through to retail energy prices, it will exacerbate the fall in real incomes for UK households and further increase UK CPI inflation in the near term. CPI inflation is expected to rise more than forecast in the May Report, from 9.4% in June to just over 13% in 2022 Q4, and to remain at very elevated levels throughout much of 2023, before falling to the 2% target two years ahead.

GDP growth in the United Kingdom is slowing. The latest rise in gas prices has led to another significant deterioration in the outlook for activity in the United Kingdom and the rest of Europe. The United Kingdom is now projected to enter recession from the fourth quarter of this year. Real household post-tax income is projected to fall sharply in 2022 and 2023, while consumption growth turns negative.

Despite being so negative about the economy, the BoE still felt obliged to hike rates because the inflationary pressure is so great. And bear in mind that the UK is less exposed to natural gas prices than several of the bigger EU economies, such as Germany, Italy and the Netherlands.

To see its Eeyore-like pessimism in handy graphical terms, here is an illustration of how their forecasts have changed since May, compiled by Societe Generale SA. The transformation in its expectations for inflation over the last 18 months is awe-inspiring to behold:

To show the scale of the long-term damage that has already accumulated, and which the central bank believes is about to be further compounded, this chart from BNP Paribas shows the current forecast compared to the trends before the Global Financial Crisis, and the comparison to the trend of growth between the GFC and the pandemic. If the BoE proves right, then British gross domestic product in 2025 will be a third less than it was reasonable to expect given the growth rate before the financial crisis:

It’s not big news that a group of well-informed economists, such as the team at the BoE, would conclude that the UK outlook was this bad. It’s not even that big news that the central bank is admitting it was wrong. Plenty have had to do that in recent months. It’s the candor and honesty with which it is laying out such a severe inflation forecast, while predicting that a severe recession will be needed to deal with it, that takes the breath away. I cannot remember a central bank of a large industrialized country being this negative about its own economy. 

The sheer bearishness of the outlook is a big deal. Many of us spend our time demanding more in the way of brutal honesty from central banks. This is what it feels like when we get it. I agree with the verdict of Ross Walker, chief UK economist at NatWest Markets:

The immediate inflation outlook is now so dire that the MPC feels it has no option but to engineer a more severe economic downturn in order to bring inflation down. There is no longer any meaningful ‘trade-off’... no ifs, no buts... a recession is unavoidable. Today marks a deeply sobering shift in policy. 

Can we use Britain’s problems to project developments elsewhere? Only to a limited extent. It has problems with labor shortages that nobody else can match. At the risk of reopening political wounds, this is probably because of Brexit, which has made it less attractive for foreign migrant workers to come to the country. The regular survey of employers complaining of labor shortages, carried out by the Confederation of British Industry, suggests that the national labor shortage is now acute, and that this is likely to lead to more inflation. This chart from Ian Harnett of Absolute Strategy Research illustrates the phenomenon beautifully:

As a relatively open economy when compared with the US (imports are 28% of GDP, compared to 13% in the US, according to the World Bank), the UK is also more prone to suffer a pass-through from a weakening currency into higher inflation. But note that most of the big European economies are even more exposed to imports. The country doesn’t derive much export revenue from natural resources any longer, and natural gas promises to be a more acute problem this winter than in the US (although less than in continental Europe). 

The Bank of England also has a problem with obdurately strong demand for gilts (in part due to enlightened reforms that forced Britain’s pension funds to buy bonds to cover their liabilities). This makes it hard to push rates up to levels where they really depress demand. Before the financial crisis, gilt and Treasury real yields tended to trade together. They parted company in 2013 (the year of the Taper Tantrum in the US) and widened significantly after the Brexit referendum in 2016. While US 10-year yields are now slightly negative, equivalent real gilt yields are two percentage points below zero. That makes it harder to tighten financial conditions:

So Britain is to some extent a special case that we would expect to have a more serious inflation issue than other countries. But everyone needs to heed the bottom line that its central bank is now prepared to say in as many words that inflation is going to hit double digits for a while, and that the country will spend more than a year in recession. Governors of the Federal Reserve have been sounding hawkish this week, but they haven’t gone to the lengths of predicting a recession. That moment will probably come, and it will hurt when it does.  

Or will it? These epochal developments slipped through the market like water off a duck’s back. Gilt yields responded to the news of rate hikes and higher inflation ahead by falling. In this case, the bearishness of the forecasts might reasonably offset the higher interest rates. But UK stocks also managed to avoid falls. The FTSE-100 — which includes many multinationals not greatly exposed to the British economy — was flat, gaining 0.03%. But the FTSE-250, including the kind of domestically focused companies that would have found the BoE’s announcement poisonous, put in a gain of 0.68%. That seems to be taking the British stiff upper lip too far. Lower bond yields in their own right justify paying more for stocks; promises by the central bank to crash the economy, all other things being equal, suggest share prices should go down. There’s an unwelcome whiff of denial in this, and it’s not restricted to Britain.

All of this plus a historic heatwave, and a summer-long contest to find a new prime minister to replace the inveterate liar who’s just been forced to stand down. It’s really not a good look. But on the more positive side, as Eeyore once pointed out, there hasn’t been an earthquake recently. 

Quantifying Rates and Stocks

In a market downturn, it’s challenging to find anywhere to invest. But beginning last year, one vehicle may be worth considering: active quantitative equity funds. Since the pandemic, systemic active funds have outperformed their benchmarks after three dismal years of performance from 2018 to 2020.

Joseph Mezrich, head of quantitative strategy at Nomura Securities International, and his colleagues, Lai Wei and Thelonious Jensen, credit the success of equity quant funds over the last two years largely to the upward trend of long-term interest rates. It’s a pattern. Since 2010, they found that equity quant funds have performed well when rates have risen and poorly when rates have dropped. The persistent low rates of that era were a problem for them — and rising rates, if they persist, will be just what they need.

Actively managed equity funds run with the benefit of human discretion, in contrast, have underperformed their benchmarks after fees even more severely over the past two years than they did over the previous decade:

“It is no coincidence that value investing has made a remarkable recovery as equity quants have rebounded,” they wrote in a note Thursday. “It is also no coincidence that equity quants and value investing both recovered as interest rates powered higher after bottoming on August 4, 2020. In fact, the continued success of both quant and value depends on the direction of interest rates.”

In 2021, almost 67% of quant funds outperformed and in the first half of 2022, 60% outperformed on asset-weighted basis — and these figures are after fees have been taken into account:

The trio offer two reasons why the success of quant equity funds is linked to the direction of interest rates. First, US large-cap quant funds, in aggregate, have a consistent value bias. “Value has been driven by the direction of rates for more than a decade,” Mezrich said. “Since quant equity funds have consistent and substantial value exposure (but varying and sometimes near-zero momentum exposure), their success has been similarly influenced by the direction of long-term rates.”

Beyond that, funds usually deploy many factors, even though they tend to value-heavy. They tend to be least diverse, and therefore most value-heavy, however, when rates have fallen — which has the effect of intensifying their exposure to value. Diversity then tends to increase  — generally a good thing for performance — as rates rise. 

As the chart shows, the value-rates connection emerged in 2010, after the GFC. Zooming in, Mezrich notes that this became even tighter after 2018:

What happened then? Post-GFC, rates have been unremittingly low, with the 10-year Treasury yield only rarely breaking 3%. That’s changed corporate behavior in a way that shifted the balance between growth and value companies>?

“This environment of historically low rates has led to corporate borrowing with very different debt profiles between growth and value companies. Very low rates have made borrowing attractive and growth companies have relied more on long-term debt than value companies. Before 2010, the percentage of corporate debt that was long-term was basically the same for growth and value companies. Since then, growth company debt has been skewed more to longer maturities than value company debt... One could then argue that this gave rise to the relationship between long-term interest rates (as represented by 10-year Treasury yield) and the performance of value vs. growth.”

The big question now is: Can good quant performance continue? As so often these days, it all depends on the macro: 

“If the market continues to price a slowing economy, a replay of the upward movement of rates that powered the recovery of value and equity quants is unlikely. But the path of interest rates can surprise. Can value and quants continue to win? That depends on the direction of rates.”

Add quants to the ranks of those fervently hoping that the Bank of England has it wrong.  

—With assistance by Isabelle Lee

Survival Tips

Andrew Bailey of the BoE was channeling a long and distinguished British tradition of curmudgeonliness. Perhaps the greatest example is the Monty Python “Four Yorkshiremen” sketch (seen here in an early version, and here in its finally evolved form) which is, as all readers should know, a high point in western civilization. If you don’t already know it by heart, here’s the script. 

The 1960 ground-breaking satire “Beyond the Fringe” offered the Aftermyth of War and also this take on the End of the World, in which a young Peter Cook predicted a “mighty wind” that will not be so mighty as to blow down the mountaintop on which he’s hiding. His listeners included Dudley Moore, Jonathan Miller and Alan Bennett. And then Tony Hancock made a career from extracting comedy from utter misery and boredom as in this brilliantly lip-synced version of his sketch about a dull Sunday afternoon. It’s an appallingly boring Sunday, and it’s hilarious. You can listen to the full audio here; you could also try The Radio Ham, which was reconstructed decades later by Paul Merton. 

Or if you want more recent grumpy old men, try Jack Dee on electricity prices (more topical now than when he recorded it), or Les Dawson on life. And if you want something musical, back when I was a student we were all into this band that sang about nothing except how miserable and unhappy they were. And it was great. Have a good weekend everyone, and try not to worry about non-farm payrolls. 

More From Other Writers at Bloomberg Opinion:

• Germany’s Switch to Diesel Comes at a Cost: Javier Blas

• This $200 Billion Bubble Stock Is No GameStop: Matthew Brooker

• BOE Gives a Lesson in Honest Central Banking: Mohamed El-Erian

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

John Authers is a senior editor for markets and Bloomberg Opinion columnist. A former chief markets commentator and editor of the Lex column at the Financial Times, he is author of “The Fearful Rise of Markets.”

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