Chancellor Philip Hammond is expected to announce some loosening of fiscal policy in next week’s Budget. There’s a simple test of the extent to which he does so: what happens to interest rate expectations? If these rise, it’ll be a sign that futures markets expect a significant loosening. If they don’t, it’ll tell us that talk of loosening is just that – talk.
I say this for a simple reason. The Bank of England believes that inflation tends to rise when aggregate demand exceeds the economy’s potential supply. A significant loosening of fiscal policy should raise demand and hence incipient inflationary pressures. Given that the Bank has a target of ensuring inflation of around 2 per cent, this should lead to higher interest rates.
For a given inflation target, looser fiscal policy means tighter monetary policy.
This poses the question. Assuming we get some kind of loosening, would this be bad for equities, given that interest rates would be expected to rise?
Simple correlations tell us that, in the past, fiscal loosenings have indeed been associated with poorer equity returns. Since 1986 the correlation between changes in the fiscal stance (measured by the change in cyclically-adjusted net borrowing) and annual All-Share returns has been minus 0.28. Equities did badly, for example, in 2002-03 and in 2008-09 when fiscal policy was loosened.
In one sense, this is surprising; fiscal policy is announced in advance and so the correlation here should be zero because shares should factor news about future policy into prices immediately.
Such simple correlations are not convincing, however. Governments loosen fiscal policy when the economy is doing badly and it could be that it is the weak economy rather than the fiscal loosening that hurts shares.
To check this, I looked at the correlation between changes in cyclically-adjusted net borrowing and annual All-Share returns, controlling for GDP growth and the lagged dividend yield. Doing this shows that there remains a negative correlation between fiscal expansions and equity returns over the last 30 years. But it falls a little short of conventional measures of statistical significance – although whether those measures are themselves useful is itself in question. Sometimes, fiscal loosenings have been accompanied by good rises in shares: this happened in 1992-93 and 2003-04.
The historical evidence, then, isn’t clear.
Cyclically-adjusted net borrowing, % of GDP
In theory, though, there’s a reason why looser fiscal policy might be good for equities. When rates are near rock-bottom, as they are now, conventional monetary policy cannot do enough to cushion the economy from recessionary shocks*. This increases the risk of a severe downturn, which should hold down share prices. Anything that returns interest rates to normal reduces this danger by giving the Bank of England more policy ammunition. In reducing the risk of a sharp downturn, share prices should rise – because in effect, one obvious tail risk is diminished.
There’s another effect a looser fiscal policy might have. Standard economic theory tells us it should strengthen sterling. This is especially possible given that the pound is already cheap in real terms.
This could be bad for stocks with big overseas earnings who will see the sterling value of those earnings fall. But it might favour some domestically-oriented stocks – at least those that don’t have big debt or strong overseas competition but do import a lot. In effect, the winners and losers from a fiscal easing are the reverse of the winners and losers from sterling’s fall after the EU referendum: overseas earners lose but retailers might win.
I don’t say all this to advocate that you change your equity strategy not least because it’s possible that underneath the talk of giveaways in his speech Mr Hammond will not in fact change overall policy much. If he does loosen policy, however, domestically-oriented stocks might benefit, and such benefits might not be immediately wholly reflected in share prices on the day.
*Yes, negative interest rates are feasible, but as they are a tax on banks they mightn’t be expansionary. With gilt yields so low, further quantitative easing might not be as effective as it was in 2009. And while less conventional policies – such as simply printing money and giving it to everyone – would work, the Bank wouldn’t implement these quickly.
