In his recent testimony to MPs, Bank of England Governor Mark Carney made headlines by claiming the Brexit vote had made British households £900 poorer than they would have been if Remain had won. Most of the media coverage dwelled on the political implications, including an apparent backlash from prominent pro-Brexit politicians. While we remain politically agnostic, we also believe it is important for investors to understand some of the flaws inherent in Carney’s estimate. A closer look at his methodology, in our view, shows why his statement need not darken your view of the UK’s economic fundamentals – or its equity markets – in the post-referendum environment.
First, consider Carney’s actual words. While many headlines used phrasing like ‘£900 worse off,’ what he said was this: ‘Real household incomes are about £900 lower than we forecast in May of 2016, which is a lot of money.’ In other words, ‘real’ (meaning inflation-adjusted) household incomes have not necessarily fallen across the board. Rather, they did not grow as much as the bank initially projected. Similarly, we saw headlines interpreting his comments about GDP growth as meaning the UK economy was £40 billion smaller. But here, too, he was referring to the difference between the actual outcome and the bank’s earlier projections: ‘If you look at where the economy is today, relative to that forecast, it’s more than 1 per cent below where it was, despite very large stimulus provided by the Bank of England, a fiscal easing by the government and global and European economies, which are much stronger than they were previously. If you adjust for those factors, the economy is about one and three-quarters – one and a half, one and three-quarters, up to 2 per cent – lower than it would have been.’
Carney went on to say that, in his view, the question to ask was how much responsibility the Brexit vote bore for this discrepancy. Yet, in our view, the real issue here is that central bank projections quite often turn out to be incorrect. Therefore, we believe any presumption that the bank’s forecasts would have been correct had it not been for the Brexit referendum is a fallacy. Official forecasts are only as good as their inputs and inherent assumptions. Many rely on historical averages and relationships in order to guess the future. For example, many models still use an assumption about unemployment and inflation known as the Phillips Curve, which holds that as unemployment falls, wages rise and inflation accelerates. Yet economic reality has disproved this theory repeatedly, most recently with below-average inflation accompanying decades-low unemployment figures in the US. Similarly, throughout the 1970s, high inflation often accompanied high unemployment in the US, UK and elsewhere in Europe. We believe any economic forecasts using the Phillips Curve’s underlying presumptions therefore have a high likelihood of proving inaccurate.
It is entirely possible that uncertainty in the two years since the referendum has weighed on the UK economy, leading to weaker investment and slower GDP growth. However, it is impossible to know for sure – and, in our view, equally impossible to precisely measure the potential shortfall. This is because we lack what scientists call a counterfactual – a control group. For instance, analysts have long argued that Brexit made the pound weaken and caused higher inflation that weighed on real incomes. But we believe it is necessary to consider whether the pound would have weakened anyway during the past two years. Our research and analysis, as well as our investing philosophy, hold that all else being equal, money flows to the highest-yielding asset. Therefore, we believe interest rates are an important driver of currency moves. The US Federal Reserve has raised American short-term interest rates five times since the Brexit referendum, placing the effective federal-funds rate at 1.7 per cent [ii]. According to the Bank of England’s May 2016 forecast, the ‘market-implied path for the Bank Rate’, which measures investors’ expectations for future moves in the Bank Rate, showed Bank Rate hitting just 0.8 per cent by the end of 2019 (and only modestly exceeding 0.5 per cent by mid-2018). This doesn’t guarantee rates would have actually been so low today were it not for Brexit, but we do think it raises a question: might money still have flocked from sterling to the dollar, seeking a higher return, and pulling the pound lower? In our view, the impossibility of answering this question demonstrates the lack of a strong counterfactual.
These issues show why we believe investors should not let official forecasts – whether from a central bank, government or major economic organisation like the International Monetary Fund – influence their view of the equity market. Forecasts are not carved in stone. They are subject to change and error. They are also influenced by bias, be it political or which economic school of thought the forecaster favours. Monitoring forecasts can help you gauge investors’ economic expectations, which can influence sentiment, but we don’t believe a bad forecast is inherently a reason to be bearish. Nor, in our view, is a missed two-year-old forecast. Carney’s statement doesn’t automatically mean Brexit weakened the economy. It could just mean the bank’s models need work.
Fisher Investments Europe Limited, trading as Fisher Investments UK, is authorised and regulated by the UK Financial Conduct Authority (FCA Number 191609) and is registered in England (Company Number 3850593). Fisher Investments Europe Limited has its registered office at: 2nd Floor, 6-10 Whitfield Street, London, W1T 2RE, United Kingdom.
Investment management services are provided by Fisher Investments UK’s parent company, Fisher Asset Management, LLC, trading as Fisher Investments, which is established in the US and regulated by the US Securities and Exchange Commission. Investing in equity markets involves the risk of loss and there is no guarantee that all or any invested capital will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world equity markets and international currency exchange rates.
This document constitutes the general views of Fisher Investments UK and Fisher Investments, and should not be regarded as personalised investment or tax advice or as a representation of their performance or that of their clients. No assurances are made that they will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts may be, as accurate as any contained herein.
[i]Source: St. Louis Federal Reserve, as of 23/5/2018. Effective federal-funds rate on 22/5/2018.