Financial markets and global economic developments

1.1 Global economic developments

UK-weighted global GDP growth in 2018 Q4 is expected to have been lower than projected in the November Report at 0.4%, and lower than in the first half of 2018 (Table 1.A). That reflects softer data in a number of economies. Growth in the euro area has been weak, averaging 0.2% a quarter in 2018 H2, although some of that may reflect temporary factors. Growth in China weakened, while indicators point to lower growth in the United States in Q4. The slowdown through 2018 has partly reflected the past tightening in global financial conditions, as policy was tightened in the US and China. It has also been associated with slowing world trade growth: annual growth in world goods trade fell to 2.8% in the three months to November from around 5% at the start of the year (Chart 1.1). The recent decline has partly reflected the impact of higher tariffs on trade between the US and China.

In part reflecting weaker data, sentiment in financial markets around global growth prospects has deteriorated and that has affected asset prices. Equity prices in advanced economies fell sharply at the end of 2018 before recovering in the run-up to this Report (Chart 1.2). In contrast, equity prices in some emerging market economies, where growth appears to have stabilised after slowing earlier in 2018, have risen somewhat since November.

Non-financial corporate bond spreads have widened (Chart 1.3), also partly reflecting the deterioration in sentiment around global growth prospects. Market intelligence suggests that other factors may have played a role as well, including concerns about particular sectors and issuers and the end of ECB corporate bond purchases. Spreads are now closer to their historical averages, having been compressed for some time.

As sentiment about the global growth outlook has worsened, market expectations for the future path of policy rates have adjusted downwards (Chart 1.4), also reducing longer-term interest rates (Chart 1.5). Those falls in market interest rates broadly offset the moves in equity prices and corporate bond spreads such that global financial conditions are little changed since the November Report (Chart 1.6).

Oil prices have fallen sharply and are around 25% lower than they were in the run-up to the November Report (Chart 1.7). While the weaker global demand outlook is likely to have weighed on prices, supply factors, such as increased Russian and Libyan production, also appear to have been important. Consistent with that, the prices of some other commodities that tend to be sensitive to global demand, such as metals, have fallen by less.

While the fall in oil prices will give some support to global GDP growth, four-quarter growth is still expected to slow from 2.4% in 2018 Q3 to 1.9% in 2019 Q3, slightly below its estimated potential rate. That slowing is somewhat greater than was anticipated in November. Further out, growth is expected to stabilise, supported by the lower path for risk-free interest rates (Section 5).

Euro area

Quarterly euro-area GDP growth averaged 0.2% in 2018 H2, lower than 0.4% in 2018 H1 and substantially lower than the average of 0.7% over 2017 (Table 1.A).

GDP growth in 2018 H2 was affected by temporary factors. In Q3, growth was affected by a fall in production in the auto sector. That had a particularly marked impact on German output, which contracted. New EU vehicle emissions standards were introduced at the start of September and resulted in significant bottlenecks in car production. It is possible that temporary factors have continued to affect growth in Q4 as recent protests in France have disrupted some service sector activity.

Underlying growth in the euro area also appears to have slowed in 2018, however. Net trade dragged on quarterly growth through much of 2018, compared to a marked boost in the previous year. Export growth to China and other emerging market economies (EMEs) fell markedly in 2018 H1 as demand growth in those countries slowed. Increased trade tensions, which have weighed on world trade more generally (Chart 1.1), may have affected euro-area exports since.

Despite the slowdown in growth, the euro-area unemployment rate was 7.9% in December (Chart 1.8), its lowest rate since 2008 Q4. At the same time, euro-area wage growth has continued to pick up. As rising wage growth leads to a gradual building of inflationary pressures, core inflation is expected to rise gradually in coming quarters. Since November, the European Central Bank (ECB) has made no changes to policy rates and has ended net purchases under the asset purchase programme.

Euro-area growth is projected to remain sluggish in the near term (Table 1.B), as some of the factors that have weighed on growth persist. The euro-area PMIs were weak in January, falling to their lowest levels in over five years. Some risks to the outlook have moderated somewhat. Political risks in Italy have lessened following the Italian government’s 2019 budget plan being agreed with the European Commission at the end of December. Consistent with that, long-term interest rates on Italian government debt have fallen back (Chart 1.5).

The United States

GDP growth in the US had been strong through much of 2018, driven by solid domestic demand. That was supported by strong employment growth and fiscal policy. Tax cuts announced in December 2017 boosted business and consumer spending. Continued growth is judged to have absorbed spare capacity fully in the US economy. The headline unemployment rate was 4.0% in January while wage growth remained firm. The Federal Open Market Committee (FOMC) continued to tighten monetary policy during 2018 with the target range for the federal funds rate reaching 2¼%–2½% in December.

GDP growth is expected to have slowed in 2018 Q4, to 0.5%, 0.3 percentage points lower than expected in November and down from 0.8% in Q3. Part of that slowing is likely to reflect some fading of the boost to investment from corporate tax cuts. Growth in spending on new equipment has slowed since the start of the year, for example.

Reflecting weaker data and market participants’ expectations of the FOMC’s reaction to that, the path of policy implied by market prices has fallen markedly since November (Chart 1.4). The median projection of FOMC members for the federal funds rate at end-2019 has also fallen from 3.1% to 2.9%.

US activity is expected to slow further in the near term as the boost to growth from fiscal policy continues to wane. In addition, the recent partial US government shutdown is expected to have a small negative impact on growth in Q1, although that should boost growth by a similar amount in Q2. Four-quarter growth is expected to fall from 2.9% in 2018 Q4 to 2.0% in 2019 Q3.

China

GDP growth in China slowed throughout 2018 (Table 1.A). Four-quarter GDP growth fell to 6.4% in 2018 Q4 from 6.8% in Q1. Much of that slowdown reflects policies enacted to reduce risks in the financial system, which have weighed on credit growth and investment.

Trade tensions with the US may have also weighed on growth. The impact of these has been apparent in financial markets: the Shanghai Composite equity index has fallen by 25% since January 2018 (Chart 1.2). There is also some evidence of the effect of higher US and Chinese tariffs in recent trade data. The value of Chinese exports to the US fell by 3.5% in the year to December 2018.

GDP growth is expected to slow a little further in 2019. While tariffs are expected to weigh on growth, stimulus provided by the Chinese authorities — for example the announced cuts to the banks’ reserve requirement ratio in January 2019 and tax cuts — should help support growth.

Other emerging market economies

Excluding China, EME growth was 0.8% in 2018 Q3 on a PPP-weighted basis, broadly as expected in the November Report but slower than growth rates over 2017. Higher-frequency indicators such as manufacturing PMIs are consistent with a further slowdown in activity in Q4.

Tighter financial conditions, in part associated with the tightening of US monetary policy, contributed to weaker activity in EMEs over 2018. Since November, emerging market currencies have appreciated somewhat (Chart 1.9) and equity indices have outperformed those in advanced economies (Chart 1.2). Financial conditions in Argentina and Turkey — the two countries which had been particularly adversely affected — have also stabilised.

Quarterly GDP growth in non-China EMEs is expected to pick up a little in 2019, broadly in line with expectations at the time of the November Report.

1.2 Developments in UK financial conditions

Concerns around the global outlook have affected UK asset prices alongside those in other advanced economies. In addition, UK asset prices have been sensitive to developments related to Brexit.

Sterling

In the run-up to this Report the sterling ERI was 1% lower than in November and was around 17% below its November 2015 peak. Sterling has been volatile over the past three months. It fell at the end of 2018 before recovering in recent weeks (Chart 1.9).

Implied volatilities from sterling options — which are measures of the uncertainty around the outlook for the exchange rate — also rose at the end of 2018 before falling back in early 2019 (Chart 1.10). They remain higher than in recent years and much higher than for other currencies.

Market participants still place more weight on sterling depreciating than appreciating in coming months. Although the cost of insuring against a large depreciation relative to a large appreciation — known as the risk reversal — has fallen since November, it still suggests that it is more expensive to insure against a large depreciation (Chart 1.10).

Market interest rates

Short-term risk-free interest rates have fallen in the past three months. In the run-up to this Report the market-implied path of Bank Rate over the next three years was around 20 basis points lower, on average, than in November (Chart 1.4). It is now expected to reach around 1.1% in three years’ time. Market intelligence suggests that the fall in rates reflects a weaker global outlook alongside concerns about Brexit, with participants anticipating a lower trajectory for rates under a disorderly scenario. As explained in Box 4 of the November 2018 Inflation Report, the MPC judges that the monetary policy response to Brexit, whatever form it takes, could be in either direction.

Longer-term UK interest rates have also fallen since the November Report, as in other advanced economies. While some of the fall at the end of 2018 was reversed in January, the yield on 10-year UK government bonds was still around 30 basis points lower than in November (Chart 1.5). Market contacts have attributed that fall to an increased preference among investors for less risky assets and a lower expected path for policy rates in the US.

Corporate capital markets

Spreads on non-financial corporate bonds across the main markets in which UK companies borrow widened markedly at the end of 2018 (Chart 1.3) and corporate bond issuance was weak. Spreads have fallen back somewhat in January and issuance has resumed at more normal levels. Falls in risk-free interest rates mean that overall financing costs for companies have only risen a little since November.

In the run-up to the February Report, UK equity prices were around 3% lower than in November (Chart 1.2). As in other advanced economies, UK equity prices fell at the end of 2018, before recovering in January.

Bank funding costs and retail interest rates

The cost of bank funding in capital markets is important for broader credit conditions as it influences the interest rates banks charge on loans to households and companies. Similar to spreads on non-financial corporate bonds, UK banks’ unsecured funding spreads have increased since November (Chart 1.11).

The impact of these higher funding costs on credit conditions will depend in part on whether the rise persists. To the extent that Brexit uncertainty has pushed up spreads, they could fall back as clarity over the outcome increases. UK banks have not issued much debt in recent months at these higher funding spreads, in part due to strong issuance earlier in 2018. But as they will need to resume issuance in coming months, a persistent rise in spreads would increase their funding costs and put some upward pressure on the interest rates facing households and companies.

Any persistent rise in unsecured wholesale funding costs is expected to have less impact on the interest rates facing households and companies than in the past, however. As discussed in Box 1, while banks have historically used wholesale unsecured debt as a benchmark measure for their marginal source of funding, the structure of banks’ balance sheets has changed significantly since the crisis and the use of alternative sources of funding has increased. Spreads on other sources of funding, such as covered bonds, have risen by less than spreads on unsecured debt (Chart 1.11).

Other factors will also affect the interest rates facing households and companies. Retail interest rates have been stable in recent months and remain at low levels (Section 2). Recent discussions with lenders have highlighted the impact of continued competition in the mortgage market on retail rates. If competition intensifies, that would put downward pressure on mortgage rates. Further, as noted in the November 2018 Inflation Report, banks are expected to increase deposit rates by somewhat less than any pickup in risk-free rates over coming quarters. That would provide scope to limit increases in retail lending rates without affecting banks’ profitability.