18 January 2018
Be careful what you wish for
Strong economies may mean poor markets.
by Frank O’Nomics
If you are an advocate of the economics of Goldilocks (not too hot, not too cold) or Dr. Pangloss (“all’s for the best in the best of all possible worlds”) you have good cause to hope that the healthy returns from almost all asset classes continues in 2018 at a rate similar to that of 2017. In the long run the price of assets is dictated by the rate of economic growth and with global growth looking likely to be close to 4% this year, why shouldn’t asset prices continue to rise, even if they are already at historically high levels? The problems with such an up-beat outlook are that over shorter periods the correlation between economic growth and asset prices is much less clear, and the elephant in the room – the potential reversal of vast amounts of central bank liquidity provision via increases in interest rates and the reversal of quantitative easing (QE). Those most bullish for the economy should logically be the most bearish for stock prices.
A review of the stance of the major central banks gives us some colour to the situation. Tax cuts in the US should lead to a rise in capital spending, further demand for labour which increases wages, higher consumption and ultimately a tighter monetary policy. Bill Dudley of the US Federal Reserve has said that tax cuts make interest rate rises more urgent, and most commentators expect 3 or 4 increases this year. The Fed has already stopped QE and, at some stage, will start to unwind some of the $3.6trn that it spent. The ECB has remained committed to QE, having already bought Eur2.3trn of Eurozone government bonds, but they halved the rate of monthly purchases (to Eur30bn) in October. Having said then that purchases would continue to September, and that they would not raise rates until “well past” the end of QE, the minutes of their latest meeting show them trying to look beyond a breakdown in the link between growth and inflation, by looking at “supercore” inflation – that which extracts the benefits accrued due to improved technology (the so-called “Boskin effect”). This looks like a central bank looking for excuses to stop liquidity provision, and, with German growth of 2.2% last year and capital investment at 3.5%, their concerns have merit. The IG Metall union has already started to press for a 6% pay rise for its 3.9 million members.
For the Bank of England the growth outlook may not be as rosy as that for Europe, but inflationary pressures are evident and are in danger of becoming entrenched. Given that the trend rate of growth has been revised down, there is a case for raising interest rates even with growth below 2%, and deputy governor Ben Broadbent sees 2-3 more rises to come. This week’s inflation data did moderate from 3.1% to 3%, but that is still well above the 2% target. Once a programme of rate rises is properly underway, the Bank can be expected to look at selling some of the £435 billion of gilts that it bought under QE.
The Bank of Japan remains the most steadfast supplier of liquidity, maintaining asset purchases of Yen80trn per year ($700bn), with overnight interest rates of minus 0.1% and 10 year bond yields capped at around zero. However, even here the Bank acknowledges that growth is expected to continue and markets will start to speculate over when the taps will be tuned off.
Ultra low interest rates and QE may not have produced much monetary inflation as yet, but it has certainly turned the tide. What it has produced is a significant amount of asset price inflation. Maintaining those asset price levels without continued QE may prove difficult, and is likely to be downright impossible if QE starts to be reversed and those huge central bank bond portfolios are unwound. Even the modest prospective rises in interest rates in the US and the UK could have a profound effect. Equity market levels are largely justified by the yields being offered, but in the US 2-year yields are already above that offered by equities so there is now no additional reward for taking the risk of stocks. So far longer yields have been more resilient, but they are likely to start to come under more pressure given the prospect of central bank sales. 10-year bond yields have been trending down for over 30 years in the major markets, but there are signs that this trend may be coming to an end. If one is looking for a prompt for the equity market correction it could be a sharp rise in bond yields.
As ever there may be a bigger danger in being out of markets. It does seem that the correction in bond yields could develop into a proper bear market and so they are best avoided, but for equities it would be very unusual to see a major correction without an increase in volatility, and such a correction would be unlikely to turn into a rout without an economic recession. It also may well be that, rather than creating a significant increase in investment, US tax cuts just help corporate balance sheets and incite a wave of mergers and acquisitions. In such a scenario, being underweight in equities would have a high potential opportunity cost so perhaps the best policy is to maintain positions, but keep a wary eye on bond yields breaking above their long-term average levels, a move that would seriously challenge equity valuations. In that case the punchbowl will have been removed and the party will be over.