We now view global central bank policy as at somewhat of a crossroads, with half of the developed world continuing unconventional policies such as quantitative easing and the other half moving away from that to a new policy phase.
Global central liquidity measures have played a pivotal role in the financial market recovery since the credit crisis in 2008-2009. For a significant period of time, (indeed half a decade in the USA), the majority of developed market central banks have stood unanimously behind an ultra-low interest rate policy and a variety of unconventional policies designed to stimulate growth. We now view global central bank policy as at somewhat of a crossroads, with half of the developed world continuing unconventional policies such as quantitative easing and the other half moving away from that to a new policy phase. These differences have important consequences for a long-term investor; we would argue central bank policy has rarely been in a more prominent place for investors.
Quantitative easing, a relatively abstract academic concept never put into practice in any significant capacity until recently, is actually quite simple to understand. Your central bank buys low risk bonds to suppress their yield, which pushes financial market investors to seek out a higher return. The direct effect is that asset prices rise, ensuring that deflation does not occur on an economy-wide scale. The hoped-for secondary effect is better credit growth and growth in the real economy. The US Federal Reserve and the Bank of England were the early and aggressive adopters of this policy and, although there were differences in implementation and timing, both used the idea on a spectacularly large scale relative to their economies. Both the US and the UK appear on a trajectory to end their experiment with unconventional policy.
In the UK, GDP growth is on a sound footing as compared to the last several years. Strength is coming across a broad base, but is particularly notable in the consumer sector of the economy with consumer confidence and retail sales having risen strongly, after languishing for several years. Housing’s contribution to growth and confidence is perhaps the single most debated statistic in the UK, with home prices in London and the Southeast experiencing nearly 20% annual gains in some areas. The Head of the BoE, Governor Carney, has called the housing market “frothy” and reminded financial markets not to be complacent about record low base rates. Markets have unsurprisingly and rightfully started to price in UK rate increases from early to mid-2015, which would make the UK the first of the major developed market central banks to raise rates.
Although there has been considerable volatility in economic figures in the US, we believe that the underlying trend in GDP growth is also better and lies somewhere in the 2.5% range. This is greater than the 2% pace we have seen in the better years of the current expansion in the US. Similar to the UK, consumer strength and housing market stability support the notion that the growth trend is mildly more positive. Over the last several years, the unemployment rate in the US has improved substantially as well, supported by decent job growth. Inflation, judged by the Fed’s preferred broad measure of prices, the Core Personal Consumption Expenditures Deflator (Core PCE) has been well below the Central Bank’s 2% target, even below the 1.7% average of the last 20 years. This is partly attributed to lacklustre income growth in the US; it is far below par based upon historical measures. In short, growth is positive and inflation is under control. The US Fed is also at the end of the “active” phase of Quantitative Easing and should begin to consider rate increases from the middle of 2015, much like the BoE.
In contrast, the Bank of Japan (BoJ) remains in an active quantitative easing phase, having only started their programme in a meaningful way in 2013, roughly 15 years too late. The BOJ is still a long way from being finished with their balance sheet-increasing phase and they are likely a number of years from contemplating increases in their base rate. Similarly, the European Central Bank (ECB) only adopted any kind of quantitative easing in the latter part of 2014. Though they adopted a negative deposit rate, itself a highly experimental and aggressive policy, and certain term-borrowing programmes designed to stimulate bank lending, their previous attempts were only aimed at addressing a supply-side problem: availability of credit. It will take a considerable period of time for them to implement a QE program and build a portfolio before they can assess whether it is having its designed effect, which is to stop measured inflation from falling. Therefore, the ECB, like Japan, is also a long distance from contemplating a rise in interest rates. In fact, European policymakers are explicitly trying to avoid a Japan-like period of negative measured inflation.
With a clearly divergent path for the Fed/BoE versus the BoJ/ECB then, what are the implications for financial markets? First, we would argue that measured inflation can remain low in this environment, with two of the world’s largest central banks still fighting deflation. In the context of low inflation, bond yields may not rise as far or as quickly as many forecasts predict, including those of the Fed and BoE themselves. Our forecast is for the US Fed to raise rates eventually, but in a well-choreographed and gradual way, with an endpoint, or top, well below previous periods of Fed tightening. Liquidating fixed income portfolios for cash in anticipation of the next historic bond route does not look to us like the best strategy in that environment. Similarly, if some central banks are removing monetary liquidity at only a measured pace and others are still adding to global liquidity, tempering the possibility of a detrimental spike in rates, we think equities can continue to perform at a level better than the fixed income markets over the long term. Certainly there will be periods of volatility in riskier assets and central bankers are not immune from policy errors, but weekly or monthly volatility should not alter a long-term investor’s view.
“…the majority of developed market central banks have stood unanimously behind an ultra-low interest rate policy and a variety of unconventional policies designed to stimulate growth.”