Despite a surge in new cases of coronavirus infections in Britain, the RSM UK Financial Conditions Index remains 0.1 standard deviations above neutral as investors focus on what is expected to be a strong economic rebound this year.
We expect growth to expand at 4.2% this year and 7% next year.
It is clear that policies to address the surge in cases and deaths attributed to COVID-19 – U.K. cases are rising by 40,000 a day and deaths are averaging 1,200 per day – will result in a decline of gross domestic product near 4.5% in the current quarter, which would meet the criteria for a double-dip recession.
But those policies came only after infections and deaths were allowed to skyrocket in what might turn out to be the 11th hour of the pandemic. Though the vaccines have arrived, the human misery and the potential for economic disaster have soared.
As we found after the last existential shock to the economy – the 2008 financial crisis – the longer and deeper the downturn, the greater the likelihood of long-term detrimental effects on the labour force, reduced and delayed investment, and diminished potential economic growth.
The impact of the latest coronavirus shutdown is already visible in the downturn of service sector output. Depending on the success of the vaccine, service sector employees could suffer the worst consequences of the shutdown and then lead the economy out of recession.
There are bound to be permanent furloughs in the retail and hospitality sectors, for whom the long-term effects have yet to be addressed.
Yet the buildup of savings in U.K. households and the release of pent-up demand following the widespread distribution of vaccines will be the primary catalyst for recovery.
As for the production sector, the outsized role that manufacturing plays in the overall economy will remain of great concern if trade between the U.K. and its trading partners becomes an inefficient exercise.
There have already been reports of production being moved to the continent to avoid the artificial roadblocks of Brexit.
The Bank of England is doing its part in maintaining financial stability and commercial viability through an extremely accommodative monetary-policy stance, and its commitment to being the lender of last resort. The fact that financial conditions are barely positive for the first time since 2020 is testament to that commitment.
RSM UK Financial Conditions Index
We designed our RSM UK Financial Conditions Index to quantify the degree of risk being priced into the asset markets. We would expect the index to mean revert as the business cycle progresses, with values greater than zero indicating reduced stress within an accommodative financial environment necessary for investment and growth.
Conversely, index values less than zero indicate increased levels of risk and a tightening of financial conditions, suppressing the propensity to borrow and lend, and implying slower growth in the coming quarters.
Our index has reacted accordingly to external shocks, dropping significantly below normal by two standard deviations during the late-1990s Long Term Capital Management-Russia financial crisis, dropping to 10 standard deviations below normal during the 2008-09 financial crisis, and then by more than two standard deviations below normal during the 2011-12 European debt crisis.
The financial markets have similarly responded during the Brexit era, with financial conditions worsening by 1.4 standard deviations at the time of the Brexit referendum and then again during the pre-Brexit political turmoil. The collapse of the equity market during the outbreak of the coronavirus in March sent the RSM UK Financial Conditions Index to four standard deviations below normal.
As we mentioned, financial conditions have recovered since the outbreak to slightly above zero, with perceptions of slightly higher risk remaining in the equity and currency markets balanced by slightly reduced risk in the money and bond markets, which we attribute to the policies of the monetary authorities.
We expect the Bank of England to retain its defensive posture and to continue its role as the facilitator of emergency fiscal policy. The bank’s mission will be to fund government spending to keep cash in the hands of consumers and to avert a depression, and then to keep long-term interest rates low in order to finance the cost of pandemic-incurred debt over time.
It is up to the political establishment to contain the pandemic and then to accommodate the re-establishment of a fully employed, productive labour force and to foster expectations for economic growth.
In the figures that follow, we take a closer look at the performance of financial assets, assessing the amount of risk being priced into the markets, which determines the degree of financial accommodation in our composite financial conditions index.
Equity market
Despite its rebound – most recently because of confidence in the vaccine – the yearly return on a FTSE 100 investment remains below noncrisis and pre-pandemic levels. And although equity market volatility has subsided since the market crash last March, it remains slightly higher than what would be expected. Nevertheless, stress in the equity market continues to moderate.
The equity market is not the economy, but it does provide a measure of investor confidence (or overconfidence) in the ability of corporations to increase profits.
Accordingly, the violent increase in price volatility last March – which rivals the 2007-09 financial crisis – is an indication of what could happen should the vaccine’s implementation be delayed or if Brexit issues turn out to be overwhelming.
Money market
The money market is essential for business transactions and short-term funding. A shock to the financial sector causes lenders to build additional default risk into funds available to the business community. The interest rate difference between commercial rates and risk-free rates is a measure of that default risk.
During the 2007-09 financial crisis, money market spreads climbed to 250 basis points. In 2020, though money market spreads spiked in response to the March equity market collapse, the swift injection of liquidity into the commercial lending market by the Bank of England and by other central banks managed to prevent the freezing of commercial borrowing.
Because of the central banks’ swift response, the financial sectors are awash with cash. And with policy rates at the zero lower bound (or less), and with the ongoing compression of interest rates, U.K. T-bill rates are negative, Euro-pound rates and overnight indexed swap rates are a mere 4 basis points, and money market spreads remain negligible.
Bond market
The bond market provides funding for longer-term investing by businesses and governments. The yields of long-term bonds are determined by:
- Expectations of policy rates (that are determined by expectations for economic growth)
- A risk premium that investors require for the uncertainty that the path of short-term interest rates will deviate from the expected path sometime over the life of the bond
That deviation takes into account the possibility of event risk, resulting in either a negative or positive shock to economic growth, and inflation or deflation. Brexit, the U.S. trade war and the coronavirus pandemic were negative events that have yet to be fully resolved.
We are also at the end of what has been a secular decline in long-term interest rates. The worldwide decrease in 10-year government bond yields corresponds to the development of a global labour market and to the success of inflation-targeting policies among the central banks of the developed economies.
In the most recent period, the fixed-income market began losing confidence in the potential for U.K. economic growth as Brexit moved from pipe dream to reality. The consequences of putting a boundary between the U.K. and its largest trading partner have investors pricing in larger risk for growth.
Investors are for this reason demanding compensation for the increased risk of recession and deflation. Gilt yields are range-trading below 0.5% because of Brexit anxiety, with recent slight increases in reaction to rising confidence in the vaccine.
The yield-curve spread between 10-year gilts and 3-month Treasury bill rates was increasing, with higher spreads indicative of expectations for a vaccine and the prospects of improved economic growth. That upward trend has stalled because of the surge in coronavirus infections and deaths.
Note that the long-term decline in the yield-curve spread since the financial crisis is attributable to the compression of interest rates, with short-term rates approaching zero and long-term rates falling because of reduced expectations for inflation and increased risk of slower growth and increased risk of deflation.
Finally, the interest rate difference between corporate bond yields and the guaranteed return of a government-issued gilt is a measure of corporate default risk. Shocks to the real economy or to the financial sector can cause lenders to build additional default risk into funds available to corporations.
So the corporate spread that was 250 basis points at the start of the health crisis – levels seen only during the financial crisis and the European debt crisis – has now receded to below 100 basis points. We would attribute its low level in such a fraught atmosphere to the compression of long-term interest rates and the prospect of the Bank of England’s stepping in should conditions deteriorate further.
Currency market
The currency market is more difficult to relate to domestic financial conditions. An exchange rate is a two-sided security with the demand for either the numerator or denominator currency able to move the level of the exchange rate.
We look at the British pound versus the euro – its largest trading partner. The pound depreciated versus the euro leading up to the Brexit referendum in June 2016, and then appreciated as German manufacturing began moving into recession and eurozone interest rates stayed negative while the U.K. rates moved higher.
Episodes of Brexit-induced political turmoil and the coronavirus stock-market collapse caused a sharp deterioration of the pound, followed by recoveries. The pound has been range-trading, with increased COVID-19 infections in the U.K. matched by increases in the rest of the world.
Similarly, Brexit-induced trade frictions would most likely cause equal damage to both sides of the English Channel. And though a weaker pound might be beneficial for the export market, the cost of pound weakness would be transferred to the consumer sector through higher prices.
Foreign-exchange market volatility spiked during the financial crisis, the European debt crisis, the Brexit referendum and, most recently, during Brexit-induced political turmoil and the onset of the coronavirus. We would expect more of the same if U.K. trade were to devolve further or if there were hitches to the vaccine’s rollout.
For more information on how the coronavirus pandemic is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.
