In today’s Exponential Investor…
- Who’s really deciding whether to hike interest rates?
- Why rate hikes aren’t the solution to current inflation
- The beginning of the end for zombie companies?
Tomorrow, the Bank of England’s nine-member Monetary Policy Committee (MPC) will hold its penultimate meeting of the year.
Markets are pricing in a rate hike of 15 basis points (or 0.15%), the first increase in rates since mid-2018. And the first since rates were slashed to just 0.1% at the start of the Covid-19 pandemic.
But, as the UK economy emerges bleary eyed from the pandemic, what effect will hiking interest rates have on the economy?
Is the tail wagging the dog?
The belief that the rate hike is just around the corner is largely down to two factors.
First, last month Governor Andrew Bailey fuelled speculation that a rate hike was on the horizon when he told a recent meeting of industry experts that the MPC would “have to act and must do so” if there were a risk of medium-term inflation.
Many investors don’t believe that current inflationary pressures are “transitory”. They point to the consumer price index, a key measure of UK inflation, set to hit 5% this year – far above the BoE’s 2% target. Or they note that 45% of UK businesses are planning to raise prices this year, according to a survey by Lloyds Banking Group. In many investors’ eyes, that makes a rate hike a done deal.
But it doesn’t stop there. Markets are also pricing in several hikes next year too – with interest rates expected to reach 1.25% by September 2022.
Markets are very likely getting ahead of themselves.
As analysts at ING Think argue that this timeline would make for the fastest series rate of rate hikes since the financial crisis of 2008-09.
What matters is that investors have changed their views markedly in just a few weeks. Less than a month ago, markets were pricing in the first hike from in 2023.
Other members of the MPC have since attempted to curb expectations. Last month, the BoE’s chief economist, Huw Pill, declared the debate over whether to raise rates as one that remains “finely balanced”.
All of the furore over which way the MPC will vote is concerning, but not for the reasons you might think.
As I’ll delve into in a moment, a rate hike could be bad news for some sections of the economy.
But the point that appears to be missing in the headlines is that market expectations could be dictating the BoE’s decision over hikes – not the other way around.
The BoE’s “credibility” has been under fire from some investors for a while.
When investors talk about a central bank’s “credibility”, what they really mean is its ability to match its rhetoric with its actions.
In fact, the previous governor, Mark Carney, earned the title of the “unreliable boyfriend” after he was unclear about a timeline for rate hikes.
This puts the MPC in a difficult position.
Markets expect a rate hike. The MPC may feel it has no choice but to deliver one, lest investors lose faith in the institution.
If the MPC raises rates because that’s what the market expects – and not because a rate hike makes economic sense – then the BoE will prove itself beholden to market sentiment.
Why rate hikes won’t cure our inflationary woes
I could liken the use of rate hikes to halt current inflationary pressures to using a sledgehammer to crack a nut.
But that would be a slightly inaccurate metaphor.
A more appropriate example would be using a corkscrew to crack a nut: it’s completely the wrong tool.
Supply chain disruption, combined with rising energy prices and labour costs, are the chief causes of the inflation we’re seeing right now.
All of these are forms of input cost inflation – with the cost of wages and raw materials on the up, more costs are passed on to the end-consumer.
But input cost inflation shouldn’t stick around forever.
As Anatole Kaletsky, founder of Gavekal Research, argues:
“There is no convincing reason to believe that goods, services, commodities and factors of production, that were persistently in excess supply until 2019, suddenly and permanently disappeared from the world economy in 2020-21.”
This isn’t to say that some commodities won’t see a sustained rise. As I’ve argued before, there are plenty of metals needed for the green energy transition that could remain high for the foreseeable future.
And there’s an altogether different asset that one of our editors believes will soon rocket to a new all-time high…
But this is the exception. When prices are rising due to input cost inflation, rate hikes could curb consumers’ disposable income… without doing much to lower prices.
Whether the BoE decides to tighten monetary policy tomorrow is an open question. But, given Andrew Bailey’s comments, combined with market expectations, at least a few couple of hikes are likely next year.
Put another way, tighter monetary policy is a question of if, not when.
But this is a challenge compounded by Chancellor Rishi Sunak’s decision to raise taxes to the highest level in 70 years and cut spending to key areas.
The end of the furlough scheme, a reduction in universal credit, and an increase in national insurance (paid by both employers and employees) will squeeze consumer spending.
But the chancellor’s in a tricky spot.
As he argued during the Budget, a 1% rise in interest rates would result in an increased cost to the Treasury of £23 billion. And that doesn’t take into account the fact that a large proportion of the UK government’s debt is inflation linked, either.
Plus, consumer expectations are that prices will continue to rise, while consumer confidence has tumbled since June.
All of this makes for an… interesting moment to bring in both tighter monetary policy and tighter fiscal policy.
Pulling the plug on indebted companies
Halloween may be over, but there’s something spooky afoot in the UK economy.
I’m talking about the undead. Or, more specifically, “zombie” companies.
These are companies mired in debt, and which spend nearly all of their revenue servicing that debt.
Zombie companies are only able to operate through access to cheap borrowing…
… which means, to them, rising interest rates (i.e. the cost of borrowing) are an existential threat.
How big an issue are zombie companies in the UK?
They are much bigger than you might expect. According to Begbies Traynor, a restructuring consultancy, 52% of UK firms are mired in “toxic” debt that they may never be able to repay.
Some sectors in particular are shouldering a shed-load of debt.
Two thirds of businesses in the real estate and hospitality sectors are unlikely to pay back their debt, for example.
How does Begbies Traynor define “toxic”?
Toxic debt results in a business having a liquidity ratio of lower than 1, which means that it is unable to pay bills due within a year using its current assets without any additional fundraising.
These are companies on life support in the form of cheap borrowing. Hiking rates (which makes borrowing more expensive) is the equivalent of pulling the plug on the life support machine.
Until the end of September, many of these companies have also been fuelled by government support.
Of course, many of these businesses will go on to pay off their debt and become profitable again.
But many of these companies will default, or undergo restructuring.
In a way, this isn’t an entirely bad thing.
Defaults are to the market what cough medicine is to children: they may hate it, but ultimately, it’s good for them.
Because it ensures that the best businesses with the best practices survive.
If a company is forever teetering on the edge of collapse, then it isn’t investing in future growth. It’s not developing innovative new technology or practices. And it’s not paying its workers more, nor is it training them in new skills.
Until next time,
Contributor, Exponential Investor