STILL DANCING, BUT CLOSER TO THE DOOR
Global risk markets have benefitted considerably from the pick-up in global growth momentum, a stronger financial system and the US Federal Reserve (Fed) sticking to gradual monetary tightening. As we enter 2018, global economic prospects seem the rosiest for over a decade with synchronised expansion across all major regions. Additionally, in the US the fiscal package has finally been implemented and at least the early signs are positive for growth and markets. The on-going political, monetary and valuation concerns continue to be outweighed by the underlying shift in economic momentum. Following on from the last quarter’s focus on the risk of Central bank, tightening this quarter we examine what this means in reality and what the likely path is for major Central banks.
On balance, we do not expect the gradual erosion of the Fed’s balance sheet to materially disrupt markets particularly as the European Central Bank (ECB) and the Bank of Japan (BoJ) will continue to expand their balance sheets through the year. However, we do acknowledge that over time Central Banks will be less accommodative, as they either reduce their balance sheets or buy assets at a slower pace which will pose a challenge for all markets and will inevitably reduce the projected returns over the medium-term. In contrast, as inflationary pressures have remained in check even with the economic upturn it has given the Central Banks an opportunity to keep policy extremely accommodative, however, the risk is that inflation may drift higher this year.
Overall, we retain our view that the cyclical upturn has gained strength but also note that key structural undercurrents are increasingly being ignored. This document will cover our main views and the implications for asset classes.
GLOBAL MACRO OVERVIEW
Economic growth in 2017 was ahead of consensus and there is significant momentum into the New Year which should lead to a pretty decent economic outcome in 2018 in most of the major economic blocks. The key points are:
- Stronger synchronised global economic growth.
- US growth momentum is likely to receive a boost from tax cuts and potentially infrastructure spending.
- Euro Zone growth accelerating with low inflation and accommodative monetary policy.
- UK Brexit concerns having less of a negative impact across Europe but it will remain a concern for the UK and will keep monetary policy loose.
- Japanese growth expectations raised, with the BoJ remaining supportive.
- The major emerging economies are on a pretty solid growth path with Brazil and Russia on a firmer footing.
- Headline inflation has normalised but core underlying prices and wage growth remain rather subdued.
- Risk markets continue to grind higher as investors react to the economic backdrop even if valuations seem stretched.
- Government bond markets likely to be more volatile reflecting risks of monetary tightening and higher inflation.
Economic sentiment has continued to improve across developed and emerging economies as seen by a host of confidence data and real activity indicators. The Euro Zone has managed to hold onto the positive surprises, with strength across a range of economic sectors. Consequently, the post-financial crash output gaps have narrowed further bringing into sharp focus the likelihood of an end to the emergency era of low interest rates coupled with an adjustment in central bank balance sheets.
In tandem with the cyclical recovery, headline inflation has also begun to normalise, with developed economy prices edging higher towards the target rates set out by the Central Banks. However, core inflation remains subdued but surely there is a risk that the underlying dynamics may change later this year.
Talking points for 2018
1. Faster monetary tightening: Global markets have become immune to threats of higher interest rates and an end to Quantitative Easing (QE) never mind the risk of accelerated tightening. The path towards monetary policy normalisation is discussed in some detail in the next section, concluding that a gradual hiking path is most likely.
But could it be that, like the markets, we are being too sanguine given that a relatively sound case can be made for advanced economy Central banks to end QE this year and start raising rates straight away. The key catalyst for a change in rate hike expectations is likely to be a sudden jump in inflation which would fulfil the main part of the policy mandate adopted by almost all Central Banks. Interestingly it may well be that even if prices were to rise, rates may well be kept looser for longer to ensure that inflation is more than just a temporary blip.
The risk of faster monetary tightening is deemed to be relatively low in 2018 but will rise in 2019
2. Higher inflation: Central Banks responded to the fear of deflation by enacting extreme monetary loosening and can claim success in lowering this risk. However, with the global economy in full steam ahead mode, labour markets tightening across the advanced economies, commodity prices beginning to rise and output gaps being eroded could it be that inflation will finally take hold?
There is scant evidence of this at this stage, but the risks on the margin are surely supportive of just such an outcome. Mitigating factors would be a rise in productivity and a jump in the labour participation rate in advanced economies that would keep a lid on wage growth.
The risk of an upward shift in inflation expectations is relatively low this year but could become a reality in 2019.
3. A Chinese meltdown: It has been rather well documented that there has been a considerable build-up in debt post-financial crash. Initially this ensured that domestic growth was boosted and subsequently, the same recipe has been used to sustain growth at an elevated level. There are numerous academic, newspaper and investment bank articles on the subject but none of them seem to able to pinpoint when and if China will blow-up just like Japan did almost three decades ago. It could also be argued that Japan was undoubtedly far more critical for the global economy in terms of its impact on the global value chain, the importance of its banking sector, its importance to global risk markets, its status as a reserve currency across Asia and beyond and the importance of its manufacturing base. China shares many of these attributes and the fact that it is the second largest economy may well create a fear backdraft that could temporarily derail China dependant Asian economies and global risk markets, but is unlikely to have a long-lasting global impact.
An article published by the International Monetary Fund (IMF) (5th January 2018 Credit Booms – Is China Different?) provides a very detailed and expert analysis and concludes that “International experience suggests that China’s credit growth is on a dangerous trajectory, with increasing risks of a disruptive adjustment and/or a marked growth slowdown.” However, it also concludes that there are a number of mitigating factors including “high savings, current account surplus, small external debt and various policy buffers” that can “mitigate near-term risks..”.
Chinese authorities are well aware of the excesses and they have outlined various measures to wean themselves off the over-reliance on credit and state-owned enterprises. It is nigh on impossible to predict whether they can or cannot be successful.
4. Asset market turbulence as QE ends: Overall global QE has been a force for good in terms of lowering risk premia, boosting asset class returns, recapitalising banks and boosting real economic growth. One of the questions (that cannot really be answered) is how much of the QE has seeped into global markets and may well be taken out? A considered view would be that other investors may be in a position to step up to the plate but clearly any significant and early end to global QE must be seen as being disruptive, not only for markets but may also risk an economic slow-down.
We reiterate a central question: Will Central Banks really be able to wean themselves off QE in the long-term – we think not.
5. European Politics: The key Euro Zone elections seemed to pass without much concern and disruption, even though in the UK the gamble failed for P.M. May. However, is it really all so stable and positive? The reality is that Germany is still trying to get a stable coalition, the far-right has over 90 seats in the Bundestag, Austria has a right-wing government in power, Poland and the Czech governments are right-wing (albeit not extreme), Italy faces crucial elections, Spain still faces disruption from Catalonia, Brexit is continuing and Greece will be attempting to exit the bailout programme. Probably best to keep a watchful eye on Europe.
The interesting aspect of all potential talking points (not all listed above) that deal with risks to markets and economies, is that they inevitably end up with the same conclusion – Central Bankers and Banks will remain in play for a prolonged period.
MONETARY POLICY NORMALISATION
Can Central Banks finally declare victory and end the post-crash policy regime of QE and ultra-low interest rates? Given the simple fact that the global economy is on a firmer footing should this lead to a normalisation in policy?
Central banks should feel confident enough to finally embark on raising nominal and real interest rates particularly given that the reasons for their action; namely stabilising the financial system, generating faster economic growth and preventing a deflationary spiral. There has been considerable success in all three areas.
(1) The major commercial and investment banks have significantly cleansed their capital structure driven by tighter regulations (imposed by the Bank for International Settlements (BIS) in tandem with local regulators). The key core Tier 1 ratio (which sits at the bottom of the banks’ capital structure as the first line of defence in the event of a macro or market event) has more than doubled. The improvement in the core Tier 1 capital ratio has been a product of lower Risk weighted assets (RWA), a rise in paid up capital and retained earnings. The minimum capital ratio requirement is set at just 4.5%, whereas the major banks capital ratios are in double digit territory and in some cases over 20%.
(2) The risk of recession is exceptionally low and in many cases the major advanced economies will grow at the fastest sustained pace for many years.
The cyclical recovery is evident across almost all developed and emerging economies. International organisations such as the IMF and the Organisation for Economic Co-operation and Development (OECD) project growth approaching 4% in 2018 and 2019, with advanced economies accelerating. These projections have been revised higher and represents a fairly rosy picture. Consensus growth projections have also been raised further, following the tax reform package in the US.
Amongst the developed block, although the US has been ahead of the pack, the Euro Zone is likely to be at a par with the US this year, Canada is on a firm footing throwing off the shackles of the commodity price rout and Japan has also picked up steam. In contrast, the UK remains a conundrum as the reasons for a slow-down are pretty evident but the economy remains in a relatively decent, albeit unbalanced, state.
Some of the underlying weaknesses that have hampered the recovery across the advanced economies in particular may finally be coming to an end. Capital investment has been weak (particularly in light of low real rates), but companies are beginning to use their cash surpluses to raise expenditure. Banks have also raised lending given the strength of their balance sheets and due to the undoubted encouragement from the Central Banks.
Emerging economies have also regained poise, following a slow-down triggered initially by the Fed taper tantrum in 2013 and followed up the broad-based commodity rout in 2015 and early 2016. India under the more reform minded Prime Minister Mr. Modi has moved into a higher growth trajectory (>7%), China has slowed to 6-6.5% growth (with significant rebalancing challenges postponed), Brazil has begun to exit recession, although the political scandals still lurk in the shadows. Asia is the strongest of the EM regions with widespread growth, limited currency pressures and an ability to withstand US trade shenanigans.
(3) The one issue that is likely to foster cautiousness is the persistence of low inflation. Even though the fears of deflation have gone away, policy-makers have not been able to boost inflation expectations. In most cases both headline and core inflation remain below official targets as wage growth remains anaemic.
It is important to remember that inflation, nominal and real interest rates have all been on a downward path for almost three decades as inflation targeting and greater policy synchronisation came into vogue.
In almost all cases, the major developed Central banks’ have an official 2% target inflation rate. Prices have been moving higher over the past year but most of this upward drift has been recorded in headline inflation. In stark contrast, underlying inflation (excluding the cyclical impact of commodities) remains rather subdued in the US and the Euro Zone. Worryingly for policy makers, lower unemployment has failed to act as a catalyst for higher wages undermining the case for a sustained rise in consumer price inflation. It would seem that the typical labour market transmission mechanism has been compromised and would imply that in countries such as the US and UK (with sharply lower unemployment rates) job growth may have been concentrated in low wage sectors and that employees have very little bargaining power.
The deflationary impact of globalisation and the profound impact this has had on the labour market remains a powerful force for low inflation. It would however, be right to argue that the threat of deflation that was real 12-months ago has fallen away significantly over the past year and the extra accommodation that was implemented by some banks is no longer necessary. The risk is that inflation could be slowly re-entering the system and could surprise on the upside.
Federal Open Market Committee (FOMC) set for gradual hikes coupled with balance sheet tapering:
- Faster economic growth with the low inflation scenario intact
- Three potential rate hikes in 2018 and balance sheet reduction
- Nominal rates should peak at a relatively low level of 2-2.5%
- Target for balance sheet to shrink by $3 trillion, with the Fed unlikely to accelerate the reduction in the balance sheet
The Fed is faced with the one of the longest economic expansion phases, robust jobs growth, a much stronger banking system but it also has to cope with low wage growth and low inflation. The economy is certainly stronger and the annual pace of growth may finally break out of the 2-2.5% range. However, none of this provides a catalyst for accelerated monetary tightening.
The Fed tightened again pre-Christmas but the language was for a gradual upward trajectory in rates in 2018. The changing composition of the Fed’s voting members is also dovish, supporting the gradualist path. We concur with the FOMC projections for a further three rate hikes in 2018. Market expectations have always been a lot more dovish (i.e. looking for a lower rate hike trajectory) than the Fed’s forecasts and what is noteworthy is that the Fed has lowered its internal long-term rate projections. Fed working papers have also suggested that rates are likely to peak at much lower levels than historic evidence would suggest. On the margin the tax package should raise rate expectations.
The Fed has begun its balance sheet reduction programme as it tapers the repurchase schedule from coupon payments and redemptions of current Mortgage Backed Securities (MBS) and Treasury holdings. This tapering should lower the balance sheet from the current $4.5 trillion to c$1.5-2 trillion by 2020. The balance sheet will not fall to zero as the bank always holds a considerable stock of reserves and currency in circulation that will rise steadily over time. In its plans, the FOMC has indicated that it will allow $6bn and $4bn per month of Treasuries and MBS respectively, to be run-off rising to $30bn and $20bn at the end of 2019. Of course, this pace could be altered if economic conditions change materially. Technically lower demand from the Fed should be negative for the Treasury market but this impact is likely to be offset over time by the implicit monetary tightening implied by the balance sheet reduction and the likely adverse impact on economic activity.
ECB steady rate policy with 2018 QE tapering:
- Lower interest rate bound reached and no need for further rate cuts
- Growth above trend across the Euro Zone
- Deflationary risk subsides as headline inflation edges up
- Core prices and wage growth well behaved
- QE tapering in 2018, i.e asset purchases to slow
- No rate hikes in the first half of 2018 but pressures will build-up in the second half of the year
The Euro Zone backdrop has improved dramatically in recent months as Gross Domestic Product (GDP) growth has edged above 1.5%. The recovery also seems relatively widespread across most sectors of the economy. Negative interest rates, the Targeted Longer-term Refinancing Operations (TLTRO) and QE have had an impact on inflation as prices have edged higher still but remains well below the 2% medium-term inflation target. Worryingly, as with other major economies, improvements in the labour market have not translated into higher wages, with core inflation edging lower not higher.
Despite some bearish comments from Board members the ECB decided to stay the course on interest rates whilst beginning to map out a potential reduction in the pace of asset purchases, i.e. not a balance sheet reduction but rather a more measured increase in the size of the balance sheet in 2018. There is a very low probability of a rate hike in the main refinancing rate over the next 12-months. However, a small technical adjustment in the deposit rate is likely late this year or early 2019.
The trajectory of QE has already been adjusted by the ECB, with the pace of purchases at €30bn per month until September of this year (or beyond if necessary). This still represents an increase in the balance sheet of c.€300bn. Principal and coupon payments will continue to be reinvested as well. However, the December ECB meeting marked a significant shift as Mr. Draghi stated that deflationary risks have completely disappeared and that inflation should gradually move towards target in coming years. However, notably the medium-term projections (including 2020) still project inflation below target, with core inflation at 1.8% despite an upward revision to growth. This would imply that the ECB still sees significant spare capacity keeping a lid on wages. It may also be that it foresees a pick-up in productivity and an increase in labour participation maintaining low inflation.
Nevertheless, it is logical to expect pressure for QE to end in Q3 and for an adjustment to the deposit rate to intensify through the year particularly if growth expectations continue to be revised higher. A rise in inflation would make it increasingly difficult for the ECB to stick to an unchanged interest rate stance and we believe that this is a key risk for European markets this year.
The Bank of England faces a tricky situation
- Economic growth is slowing whilst inflation is above target
- Rates should remain steady in 2018 unless there is positive news on Brexit
- Risk of recession on pre-mature rate hikes
- BoE balance sheet has been static for some time, with a reduction not in sight
The Gilt market reacted adversely to a significant shift in the Bank of England’s stance on monetary policy (in the run-up to the rate hike), but has managed to stabilise since then. The outlook is rather mixed as the output gap has been eroded and headline inflation is above target. The rise in inflation has and will continue to pose a problem for policy-makers; can they continue to ignore inflation remaining significantly above target? The main concern for policy-makers is likely to be the impact of higher inflation in squeezing real incomes at a time that consumer spending is easing, creating a risk of a significant slow-down in overall economic growth.
Unlike the ECB, the Bank of England (BoE) is likely to sit on its hands for much longer given the ongoing Brexit negotiations. In addition, unlike other major economies, the UK suffered a major currency shock post-Brexit referendum, directly fuelling higher inflation. As this currency impact fades, headline inflation will edge lower in 2018. Core inflation is already under control as wage growth remains extremely subdued despite the sharp fall in the unemployment rate.