The UK’s index of leading companies, the FTSE 100, has broken the 7,000 points barrier and is approaching all-time highs at what might look like a deeply fragile moment. Markets are placing higher and higher values on British firms, despite a protracted period of uncertainty after the Brexit vote, while economies worldwide face tough conditions with little help left from central banks. So why is it suddenly boom time for traders in London’s square mile?
At first glance, this may be look like a case of “animal spirits” – those erratic bursts of market behaviour identified by the economist John Maynard Keynes in his 1936 book. Perhaps more tellingly though, the phenomenon has run in tandem with a continuous downward trend of the exchange rate of the pound to the dollar.
This simple fact means that the seemingly odd behaviour of UK investors may not be so far-fetched. The declining value of the pound means that exports are cheaper than imports. In effect, the market strength is not so much an assessment of the UK economy as it is a bet on how well UK multinationals will do selling goods in foreign markets.
This call by investors kicked in after the Brexit vote on June 23 in response to an immediate drop in the value of the pound. Of course, currency fluctuations don’t dictate everything and underlying the confidence of investors is a belief that things will only get so bad.
Before the Brexit vote, Bank of England governor Mark Carney gave a grim forecast on the uncertainty surrounding the UK’s economy post Brexit, and accurately predicted the drop in the value of the pound.
His sombre but reassuring approach did enough. Investors were given two prompts: a weak currency, but a firm hand on the tiller. This seems to have spurred their optimism that Carney would be able to set the appropriate monetary policy targets whatever the EU exit strategy and would be able to overcome any economic shocks as Britain prepares to secede from the European Union. It doesn’t mean they are right, of course, but sentiment is (almost) everything in markets.
The Bank of England’s role doesn’t end there. Since the Brexit vote, it has acted to drive down the cost of borrowing and increase spending and investment in the real economy. The UK three-month generic yield on Treasury bills has been going down. These are low-risk, short-term borrowing instruments so the drop should encourage short-term borrowers to invest in them.
From an investor’s point of view, low interest rates provide a low cost of borrowing. When companies take advantage of such a low rate, they can borrowing cheaply and use the borrowed capital to expand.
For households, the Bank of England’s strategy acts as a disincentive to put their money into savings and current accounts and should in theory encourage investments elsewhere. In other words, the only rational response for equity investors to the central bank’s initiatives is to “buy, buy, buy”.
Bringing home the Bacon
If there is a long-term prospect, it is this. The ten-year nominal yield for generic government bonds has been edging upwards. This is an indication that while short-term yield has decreased, encouraging investors to borrow and invest now, in the long-run, the rise in the long-term yields signify that, on average, short-term yields will go up in the future (thus the costs of borrowing). The message is: if you want to borrow and invest, do it now rather than later.
This likely reflects Carney’s optimism about the future of the UK’s economy in the long-run. Just like everyone else, markets don’t have enough information yet to know for sure, but the noises from the central bank and from the government are enough to underpin some measure of confidence for now.
As any UK historian will attest, Brexit is not a unique event in terms of its effect. Britain experienced a very similar episode in 1992-93 after the official German reunification a couple of years earlier, when the pound slumped from more than US$2 to US$1.42. The FTSE, on the other hand, showed a similar response to today, moving from 1,990 points in 1990 to 3,689 in 1995.
So, is it erratic animal psychology or well-versed investor rationality? Probably a bit of both. If history is any indication, it is the case that when subjected to economic uncertainty and adversity, the British people and its central bank will tend to work together to achieve economic prosperity. As Francis Bacon once said, “scientia potestas est” – knowledge is power. It is perhaps better translated as: “he who possesses (new and logical) information possesses the power to act on it”. We may not have much information right now, and little of it certain, but investors will act on what they can get.
This article first appeared on The Conversation – http://theconversation.com/uk