REMOVING THE PUNCHBOWL
Global risk markets have continued to grind higher despite rising global geopolitical tensions and a distinct shift in Central Bank language implying that the period of extraordinary monetary policy is about to come to an end. Additionally, the disappointment over the endless delays in President Trump’s economic friendly fiscal initiatives has done little to dent investor confidence. All of these concerns continue to be outweighed by the underlying shift in economic momentum which has led to a period of synchronised global economic growth. Following on from the last quarter when we focussed on the risk of Central Bank tightening this quarter we flesh this out further examining what this means in reality and examine the likely path for major Central Banks. On balance we do not expect the US Federal Reserve’s (Fed) balance sheet reduction to disrupt markets in the initial period as the European Central Bank (ECB) and the Bank of Japan will continue to expand their balance sheets. As all Central Banks stop asset purchases and then reduce their balance sheets over time, there will undoubtedly be challenges ahead for all markets and this will inevitably reduce the projected returns. The risk of Central Banks stepping away too soon is real and a major policy mistake cannot be discounted as the probability of such an outcome has increased somewhat and as a result we have reduced the risk content within London & Capital portfolios by tapering our equity weighting. Overall, we retain our view that the cyclical upturn remains intact for the time being but 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 this year has been ahead of consensus expectations but the mix has been a surprise. There is significant momentum which will lead to pretty decent economic outcomes in 2018 in most of the major economic blocks yet there are tensions that may slow-down growth. The key points are:
- Stronger synchronised global economic growth
- US growth this year is likely to be lower than most expectations at the start of the year while the Eurozone has surprised on the upside
- US growth could accelerate if tax cuts and infrastructure spending become a reality
- Headline inflation has normalised but worryingly core prices and wage growth have remained rather subdued
- Risk markets continue to grind higher as investors react to the economic backdrop
Economic sentiment has continued to improve across developed and emerging economies as seen by a host of confidence data. The Eurozone has managed to hold onto the positive surprises, with strength across a range of economic sectors. Consequently the output gaps have 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. However, core inflation remains subdued and suggests that the era of persistently low inflation will remain intact.
MONETARY POLICY NORMALISATION
The major Central Banks have increasingly voiced a willingness to remove the emergency level of monetary accommodation that has been in place during the post-financial recession period. This clearly raises rather important questions for investors and for asset allocation. Foremost, does this removal of accommodation imply that government bond yields are likely to shoot significantly higher? Second, will volatility rise and consequently will risk markets correct? Given the fact that Central Banks have forced a shift in investor behaviour, this would seem to be the logical outcome. However, the reality may well be quite different, reflecting the underlying economic backdrop and the weight of money that is coming into savings products globally.
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 obviously far greater concern over a simultaneous reduction in the size of Central Bank balance sheets. The Fed is most advanced down this path and has also begun reducing the size of its balance sheet as it reduces reinvestment into Treasuries and Mortgage Backed Securities (MBS). Others, particularly the ECB and Bank of England (BoE), have hinted at following suit at least in providing timely forward guidance but will continue to purchase assets throughout 2018.
We stress that Central Bank balance sheets will continue to rise in aggregate for the next couple of years but the pace of this increase will certainly slowdown. In order to understand the impact on the government bond market and broader risk markets, from corporate bonds through to equities, we have to look at a few moving parts such as:
The size of US Treasuries held at the Fed that will redeem and will not be reinvested:
- Due to the caps placed by the Federal Open Market Committee (FOMC) on removal of Quantitative Easing (QE) it is generally assumed that; redemptions which the Fed will fail to reinvest in Treasuries in 2018 will be roughly $250 bn.
The overall net issuance in the Treasury market taking into account overall Treasury redemptions and the refinancing needs that will be determined by the underlying budget deficit:
- Treasury redemptions in total next year are c$1.6 trillion, i.e. investors will receive this as cash in addition to coupon payments on other existing Treasury and Mortgage Backed Security (MBS) holdings
- Excluding potential tax cuts, the Fed budget deficit consensus projection is 3.8% of GDP, i.e. wholly manageable
- The potential tax cuts and infrastructure spending could be between $500 billion to $1 trillion but this is over a 10-year period and will not be front-loaded, i.e. the budget deficit will not rise by that amount immediately
- Indeed tax receipts may well rise over time if the economy responds positively lowering the impact on budget deficits
The potential flexibility that the Treasury has in changing the issuance schedule on an ongoing basis to ensure that redemptions at the Fed are less disruptive:
- The Treasury has significant flexibility in the quarterly refunding schedule that it already utilises and may well decide to issue more Treasury Bills during the next fiscal year to lower the net issuance of coupon bonds.
Flow of funds excluding redemptions into investors:
- There have been significant inflows to institutional investors, sovereign wealth funds and other long-term investor pools.Given global demographics and economic activity these funds should continue to rise
Corporate bond redemptions and potential refinancing needs:
- It is well-known that companies have taken full advantage of low interest rates to refinance and lengthen their maturity profile. Interestingly the redemption schedule over the next 3-4 years is not particularly large and should not be seen as a major burden for bond markets
The increase in the Fed’s balance sheet (c.$3 trillion) has been absorbed by both Treasuries and MBS displacing other investors who would normally have bought these securities. Of course, the underlying economic dynamics and the rising level of demand for high quality assets from other investors, led to a significant fall in the equilibrium level of bond yields, i.e. demand was significantly higher than supply forcing bond prices higher. Any excess demand from investors (that would normally have been destined for Treasuries) has seeped into other fixed income markets, equities or the real economy. It is difficult to gauge the ratio of such seepage but clearly there was quite a significant move into asset markets.
Therefore, the simplest form of the argument is that as the Fed’s balance sheet shrinks by $2.5-3.0 trillion, the level of demand for US Treasuries and MBS will need to be replaced by other buyers. All things being equal, this will need to be financed through selling off other asset classes or reduced demand for other assets thereby leading to a sell-off across all markets. In practice, the gap will not be $2.5-3.0 trillion as outlined above over the next few years but probably closer to $1 trillion. This will inevitably put pressure on all asset classes potentially reducing the future return stream across asset markets.
The Fed’s intervention also contributed to a fall in volatility, although this was not the only factor, as the primary reason has been the lower volatility in economic growth and inflation. The greater synchronisation between major Central Banks has also been a key factor. Nevertheless, volatility has been trending ever lower and the risk remains that there will be damaging spikes with asset allocation needing to reflect such potential moves.
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. The risks are remarkably high as inflation is still low and the long-term growth outlook is still uncertain. Will Central Banks really be able to wean themselves off QE in the long-term – we think not.
Background for Central Bank action
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. An important point that should not be overlooked is that inflation, nominal and real interest rates have all been on a downward path for almost three decades as inflation targeting came into vogue as did greater policy synchronisation.
It is rather important to understand the reason for Central Banks’ decision to adopt emergency measures as this will provide the rationale for stepping away, albeit very gradually. The initial response post-2008 was largely to counter three significant and dangerous developments:
- A banking crisis that infected all major centres and markets. Banks had lost faith in each other and liquidity froze, leading to significant falls in risk markets led by bank shares and bonds. Markets were consumed by fear most aptly captured by the remarkable sustained rise in both bond and stock volatility. There was a second wave in 2010/2011, as European banks faced significant pressure on the back of severe under-capitalisation and rising non-performing loans. This almost threatened to completely undermine the significant steps that had been undertaken to stabilise banks.
- There was a synchronised recession across all major economies, with an underlying collapse in corporate and consumer confidence. Unemployment rates rocketed and business investment fell sharply as credit markets froze and demand fell. Even though there was a subsequent recovery this was extremely shallow and the major economies were then left with persistently low economic growth.
- Deflationary fears across all major economies as wage growth collapsed and corporate margins went into reverse. These deflationary fears have resurfaced on a number of occasions throughout the past nine years and even now underlying core inflationary fears remain subdued. Not surprisingly the Fed remains unconvinced that the current period of low inflation is purely a transitory phase.
It was in the face of this backdrop that Central Banks had no option but to respond through cutting interest rates and launching QE. This was due to governments being either unable or in some cases unwilling, to use fiscal levers to boost demand. The Central Banks responded to real fears of ending up in a Japanese style never-ending deflationary syndrome.
However, nine years on, the Central Bankers can look back with some confidence at the success in turning away from at least two of the triple threats they faced back in 2008.
- The major banks have significantly changed and cleansed their capital structure driven on by tighter regulations (imposed by the 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 (see chart). The improvement in the core Tier 1 capital ratio has been a product of lower RWA (Risk weighted assets) and a rise in paid up capital and retained earnings. Important to remember that the minimum capital ratio is set at 4.5%, whereas the major banks capital ratios are in double digit territory and in some cases over 20%.
- The global economies have moved away from fears of slipping back into recession and the developed economies in particular seem to be on the firmest footing for almost a decade. (see charts).
The cyclical recovery is evident across almost all developed and emerging economies. The following section will examine the current and projected economic assumptions. In terms of forecasts, the IMF projects that the global economy should expand by 3.6% and 3.7% respectively in 2017 and 2018. These projections have been revised higher by 0.1% and represents a fairly rosy picture. 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 moved onto a firmer footing throwing 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 but there is widespread recovery in the region. 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.
However, 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 policy.
Emerging economies that led the world post-recession have clearly 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. The highlights are: 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, with the political scandals still lurking 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.
Even though the fears of deflation have gone away the 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.
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 or so but 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). As this base effect wears off, headline inflation will edge lower. In stark contrast, underlying inflation (excluding the cyclical impact of commodities) remains rather subdued in the US and the Eurozone. 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.
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.
FOMC set for gradual hikes coupled with balance sheet tapering:
- Steady growth and low inflation scenario intact
- One more rate hike in 2017 and three potential rate hikes in 2018
- Nominal rates should peak at a relatively low level of 2%
- Balance sheet tapering has begun and will continue at a steady pace over the next three years
- 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 third longest economic expansion phase, robust jobs growth, a much stronger banking system but it also has to cope with low wage growth 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. 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 has begun and 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 rises steadily over time. In its plans, the FOMC has indicated that it will allow $6 bn and $4bn per month respectively of Treasuries and MBS, to be run-off rising to $30 bn and $20 bn 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 QE tapering:
- Lower interest rate bound reached and no need for further cuts
- Economic rebound across the Eurozone
- 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. 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 options (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.
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 12-months. However, a small technical adjustment in the deposit rate is likely late next year.
The trajectory of QE will in most likelihood be adjusted rapidly over the first half of 2018, falling from €80 bn to €40 bn per month in the first half of 2018, and down to a monthly pace of just €20 bn in the second half of next year. This still represents an increase in the balance sheet of c.€700 bn over the next 18 months so any bearishness really does need to be tempered.
The BoE set to remove the post-Brexit rate cut
- Economic growth is slowing whilst inflation is above target
- Reversal of post-Brexit rate cut in November is on the cards
- Rates should remain steady in 2018 unless there is positive news on Brexit
- Risk of recession on pre-mature rate hikes
- 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 BoE’s stance on monetary policy. It now seems that the majority of MPC members are ready to back a 25bps rate hike next month in response to the output gap being eroded and headline inflation being above target. This has been viewed by many as the first step in a definitive shift in interest rates ignoring the underlying weakness and the threats from a messy Brexit exit.
The case for an imminent rate hike is largely predicated on the current inflation reading being above the target rate. Of course 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. On balance our judgement is that the BoE will take away the post-Brexit rate cut in November and will revert to a ‘wait and see’ stance into 2018.