Markets have sustained their cheerful mood throughout 2017 despite the US Federal Reserve tightening monetary policy and disappointment over the significant delay in President Trump’s economically friendly fiscal initiatives. However, all of the on-going concerns have been parked on the side-lines as volatility has subsided to new lows. Any macro or valuation concerns have seemingly been outweighed by the focus on a stronger and synchronised global economic recovery. We labelled our last quarterly update “Blue Skies with clouds ahead” and this quarter we see one of these clouds increasingly coming into focus; major Central Banks seem to be indicating that they are on the verge of stepping away from ultra-loose monetary policy. The key question that keeps rearing its ugly head is will this increase the probability of a policy mistake and a slump in risk markets or will this move be easily absorbed? On balance we do not expect a major policy mistake but clearly the probability of such an outcome has increased somewhat and as a result we have reduced the risk content within London & Capital portfolios by lowering our equity weighting. Overall, we retain our view that the cyclical upturn remains intact for the time being but also note that key structural undercurrents are increasingly being ignored.
GLOBAL MACRO OVERVIEW
This year economic growth has met our expectations but the mix has been a surprise:
- Stronger synchronised global economic growth
- US growth has been lower than expectations whilst the Eurozone has surprised on the upside
- Headline inflation has normalised but worryingly core prices and wage growth have remained rather subdued
- Valuations continue to be stretched as investors react to the economic backdrop
Economic sentiment continued to improve across developed and emerging economies as seen by a host of confidence data. Even the Eurozone has surprised on the upside, with strength across a range of economic sectors. As a result, the output gaps have finally narrowed, 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.
MONETARY POLICY TURNING
The major Central Banks’ have recently signalled a willingness to remove the emergency level of monetary accommodation that has been in place during the post-financial recession period. This raises rather important issues for investors and for asset allocation.
In our judgement, based on our central macro scenario, a gradual rate hiking path over the next couple of years is the most likely rate trajectory but there is far greater concern over a simultaneous reduction in the size of Central Bank balance sheets. We also conclude that the chances of a reversal in recent bearish rhetoric should not be discounted, particularly in the case of Europe and the UK. The Fed is obviously most advanced in terms of both raising rates and in outlining a fairly definitive path for balance sheet reduction. Others, particularly the European Central Bank (ECB) and Bank of England (BoE), have hinted at following suit at least in providing timely forward guidance.
The key question is why Central Banks feel confident enough to finally embark on raising nominal and real interest rates? Almost all have mixed mandates or objectives including ensuring a certain level of economic activity and generally have a target inflation of c2%. A point that should not be overlooked is that inflation, nominal interest rates 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.
The following discussion briefly examines some of the main arguments forwarded for the shift in monetary policy sentiment and should be judged in terms of the monetary policy objectives that have been adopted by the major Central Banks.
A stronger economy and higher inflation provide a recipe for tightening:
The cyclical recovery is evident across almost all developed and emerging economies. The second section examines the current and projected economic assumptions which are hardly changed from the previous quarter, i.e. steady growth and low inflation will continue. In terms of forecasts, the International Monetary Fund (IMF) projects that the global economy should expand by c2.5- 3% this year and in 2018. Consensus growth projections have also been raised marginally, despite the disappointment of a lack of delivery on fiscal policy in the US. Amongst the developed block, although the US remains ahead of the pack, the Eurozone has finally gathered steam, Canada has thrown off the shackles of the commodity price rout and Japan has also steadied. In contrast, unsurprisingly the UK seems to be entering the early stages of a slow-down. Within the Eurozone, Germany remains the shining light whereas Greece and Italy, the problem areas, continue to lurk in the shadows. Nevertheless, it would be fair to argue that the Eurozone as a whole is on a much stronger footing helped to a large extent by a stronger banking system.
The major Central Banks could therefore rightly claim a victory of sorts but the underlying tensions remain; capital investment has been weak (particularly in light of low real rates), companies remain exceptionally cash rich and banks have deleveraged and may tighten their belts further in the event of rate hikes. In contrast, consumers have, on balance, become more leveraged and will be vulnerable to rate hikes whilst with some notable exceptions, government debt levels have also continued to mount with very little room for manoeuvre on fiscal support to offset monetary tightening.
Emerging economies that led the world post-recession have regained poise following a slowdown, triggered initially by the Fed taper tantrum in 2013 and followed up the broad-based commodity rout in 2015 and early 2016. The highlights are: India, under the more reform-minded Prime Minister Mr. Modi, has moved into a higher growth trajectory (7.-7.5%), China has slowed to 6-6.5% growth (with significant rebalancing challenges postponed), Brazil is exiting recession but political scandals and volatility remain a major risk to reform. Asia is the strongest of the Emerging Market (EM) regions with widespread growth, limited currency pressures and an ability to withstand US trade shenanigans.
Almost all major developed Central Banks’ have an official 2% target inflation rate and have seen prices moving higher over the past year or so. Most of this upward drift has been recorded in headline inflation as commodity prices initially stabilised and then moved higher - particularly oil prices. There is an undoubted base impact (i.e. annual headline inflation is higher due to commodity prices now being higher than at the same period last year). This base effect will wear off and in most cases, headline inflation will edge lower into the second half of the year. In stark contrast, underlying inflation (excluding the cyclical impact of commodities) remains rather subdued and is even edging lower in the US and the Eurozone. Worryingly for policy makers, lower unemployment has failed to act as a catalyst for higher wages thus undermining the case for a sustained rise in consumer price inflation. 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.
If Central Banks were to focus purely on current inflation conditions they could justify a need for interest rate hikes, but the targets they follow are forward looking and there is little evidence to suggest that inflation is set to move higher on any sustained basis. 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 significantly over the past year and the extra accommodation that was implemented by some banks is no longer necessary.
The Federal Open Market Committee (FOMC) set for gradual hikes coupled with balance sheet tapering:
- Low growth and low inflation scenario intact
- One more rate hike is possible in 2017 and three potential rate hikes in 2018
- Nominal rates should peak at a relatively low level of 2%
- Balance sheet tapering to begin in Q4 2017 at a steady pace over the next 3 years
- Target for balance sheet to halve should be seen as a long-term substitute for rate hikes not as a complement
The backdrop that the Fed is faced with remains positive with the third longest economic expansion phase, robust jobs growth and a much stronger banking system, however, it also has to cope with low wage growth, lack of fiscal support and an economy still stuck in a 2-2.5% range. None of this provides a catalyst for accelerated monetary tightening.
The Fed has already raised interest rates and is set to raise rates once more this year and as far as the FOMC projections are concerned, a further three rate hikes are likely in 2018. Market expectations had 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. The chart reflects the fact market expectations remain below Fed projections but this gap has narrowed this year. Fed working papers have also suggested that rates are likely to peak at much lower levels than historic evidence would suggest. Additionally, the delay in the much anticipated President Trump fiscal boost is yet another factor that should trigger a bit of caution as far as the FOMC is concerned.
The FOMC has additionally outlined its balance sheet reduction programme as it tapers the repurchase schedule from coupon payments and redemptions of current MBS and Treasury holdings. This tapering is on schedule for this autumn and should lower the balance sheet from the current $4.5 trillion to c$2.5-3 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 rises steadily
over time. In its plans, the FOMC has indicated that it will allow $6bn and $4bn per month respectively of Treasuries and MBS to be run-off rising to $30bn and $20bn in 12-months’ time. 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 Quantitative Easing (QE) tapering:
- Lower interest rate bound reached and no need for further cuts
- Economic rebound across the Eurozone albeit still modest
- Deflationary risk subsides as headline inflation edges up towards target
- Core prices and wage growth well behaved
- QE tapering in 2018, i.e asset purchases to slow
The Eurozone backdrop has improved dramatically in recent months. Gross Domestic Product (GDP) growth is edging above 1.5%, with Germany forging ahead and most members states also participating in the rosier outlook. 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 but remains 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.
European government bond markets have rightly taken fright (due to fears of premature tightening) as Bund yields have edged above the psychological barrier of 0.5%. This despite the latest ECB minutes concluding that “evidence continued to indicate that progress on a durable and selfsustaining convergence of inflation towards…the medium-term inflation aim remained conditional on the very substantial degree of monetary accommodation”. Given that the underlying economy has displayed widespread strength, the conclusion that the bond market has reached is that asset purchases will be tapered quickly.
Certainly, the comments over recent weeks from various ECB Board members, such as President Draghi and Benoit Coeure, have been seen as being increasingly bearish on monetary policy. However, closer scrutiny would suggest that the ECB is staying 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 close to zero probability of a rate hike in the main refinancing rate over the next 18-months. However, a small technical adjustment in the deposit rate is likely late next year.
The trajectory of QE will most likely be adjusted rapidly over the first half of 2018, falling from €80bn to €40bn per month in the first half of 2018 and down to a monthly pace of just €20bn in the second half of next year. This still represents an increase in the balance sheet of c.€700bn over the next 18-months so any bearishness really does need to be tempered.
The BoE creates confusion but likely to delay rate hikes
- Economic growth is slowing whilst inflation is above target
- Rates on hold but signs of dissent on the MPC
- Very low probability of a rate hike in 2017 and even in the first half of 2018
- Risk of recession on premature rate hikes
- Balance sheet has been static for some time, with a reduction not in sight
The BoE has created confusion following three MPC members voting for an immediate rate hike. The ensuing soothing comments from Governor Carney were quickly undermined by the BoE’s Chief Economist painting a very bearish case, implying a rate hike is now more likely this autumn. This showed a division within the key Central Bank policy makers and rightly led to a sell-off in Gilts.
However, the case for a rate hike is largely predicated on the current inflation reading being above the target rate. It is important to remember that unlike other 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 also under control as wage growth remains extremely subdued despite the sharp fall in the unemployment rate. On balance, our judgement is that the BoE will row away from a rate hike this year and will revert to a wait and see stance into 2018.
Indeed, since the last BoE vote, the economic data has been discouraging, with a slew of statistics from retail sales, manufacturing, house prices, car sales and confidence numbers all slowing. On top of this, political uncertainty coupled with the beginning of Brexit negotiations casts a dark shadow over the economy. The BoE may yet be swayed to the bear case if the government eases up significantly on fiscal austerity following an indecisive general election. The results have raised doubts over the country’s appetite for further austerity, particularly with regard to public sector pay. A volatile future is ahead for investors.
Could Central Banks make a mistake?
The risk of a mistake has risen sharply as it may well be that Central Banks’ tightening policy is inappropriate at a time when the economy cannot withstand a removal of liquidity by focusing on current inflation indicators rather than forward looking price pressures. There is very little evidence to suggest that policy is behind the curve in any of the major economies and that markets would react adversely to delays in monetary tightening. Inflation has not only been below target for a sustained period but core inflation has persisted in a disinflationary mode.
London & Capital investors have continually pressed us on the potential mistakes that may hamper the economy and we have persistently focused on monetary policy tightening being a key potential source of concern. Recent Goldman Sachs research has rather nicely summed up our thoughts on this topic by highlighting that since 1985 the main risk (or policy reaction) leading to a recession has been monetary policy. This is not to underplay the fact that the financial collapse led to the deepest recession for many decades. Interestingly, commodity price shocks or foreign exchange disturbances have been far less potent forces in terms of economic recessions over the past three decades. Looking ahead, neither should pose a major threat to economic growth.
The risk is that growth is stronger but is still shy of the levels recorded prior to 2007. In most developed economies a loss of momentum of 0.5%-1% could be enough to trip the economy into recession and renew deflationary risks. The key questions that the policy makers will be focusing on in terms of risks are likely to include:
- Can higher interest rates provide greater confidence to companies? This is a tenuous argument built on a better return on equity and assets boosting investment, whereas the reality could be that companies may just hoard even more cash.
- Savers earning a fairer return on deposits but with disposable incomes already squeezed – in reality, could this backfire?
- High leverage consumers could be rapidly impaired by even a small rise in interest rates
Ultimately, Central Banks have a very difficult choice ahead, as even a small mistake could counteract the recovery that has finally begun. There is an increasing risk of just such an outcome and we will retain a higher cash allocation over the next few weeks.