Do Markets Believe Central Banks?

22 October 2017

Investors appear convinced that stimulative G-7 monetary policies lie behind the markets’ record-setting performance.  To be sure, that was the case between 2009 and 2015.  During the past three years, however, I believe the impact of monetary policy has been quite neutral, the key driver of markets more recently has shifted from interest rates to earnings growth. Looking forward, most importantly, I expect the influence of monetary policy will shift again, but this time from a neutral to a negative role.  The impact of this change will differ across countries and asset classes; and, accordingly should play a role in investors’ asset allocation.  Two factors will determine the influence of monetary policy on market performance: the outlook for inflation and the gap between what markets expect from central banks and what the monetary authorities deliver.

The Fed:  We Don’t Believe You!

Despite its extensive use of forward guidance and improved transparency, the US Federal Reserve has a bit of a credibility problem.  Specifically, while Governor Janet Yellen has promised three rate hikes next year (in addition to one this December), the markets barely have discounted just one! The markets disbelief is easy to understand.  In both 2015 and 2016, the Fed pledged to hike rates 3 to 4 times annually, but only delivered one increase per year.  Until recently, furthermore, the Fed forecasted the long term neutral Federal funds rate at 3.75% — they now assume 2.75% — again at odds with the market’s expectation of less than 2%.   Needless to say, American central bankers would have found life difficult as hedge fund managers during these years (although they do have a $4.5 trillion portfolio)!

However, the Fed got it right in 2017, and I suspect they will deliver also the three rate increases planned for next year.  Trends in wage and price inflation will be crucial, although bear in mind the Fed did hike three times this year, even though inflation was lower than expected. To be sure, the reasons wage and price inflation have remained so subdued despite low unemployment remain somewhat of a mystery. However, the weaker relationship between inflation and joblessness is occurring world-wide, suggesting structural issues such as weak productivity is the cause.

What we do know is that labour markets in the USA and elsewhere are tighter than a year ago. For instance, the US unemployment rate declined from 4.8% to 4.2% in the past 12 months.  In the Euro-zone, joblessness is higher, but still fell from nearly 10% to 9.1% this year. Likewise, the Japanese rate edged down to 2.8% from 3.1%.

Chart 1 illustrates that core inflation in all G7 nations (except the UK) remains below the key 2% threshold. However, reflecting the tightening US labour market, American wage growth now appears to be edging up ever so slightly.  For example, average earnings rose 2.9% in September, compared to 2.6% last year.  In contrast, wage pressures remain even more limited elsewhere.  European compensation has risen only 1.6% this year (same as 2016), while Japanese workers are only 0.9% better off than last year.  As a result, US inflation is more likely to test 2% than the other areas.

Europe and Japan: Markets and Central Banks More In Sync

As the ECB outlines its plan to taper its QE asset purchasing program (expected this week), they will need to juggle several priorities.  Before exiting the program, most importantly, they will want to ensure inflation will not continue to undershoot its 2% inflation target.  Meanwhile, the ECB is confronting a scarcity of bonds they can purchase under their self-imposed QE guidelines. In particular, they will soon hold 1/3 of outstanding German bonds.  Furthermore, the ECB will want to maintain sufficient buying capacity to be able to credibly commit to increasing QE purchases again, if economic conditions warrant such action. It is generally assumed that the ECB has roughly Euro 300 billion of remaining borrowing capacity.

The consensus view is that the ECB will taper by roughly 10 billion per month, ending the program in June 2018.  I expect they will proceed more cautiously. While economic growth is solid, unemployment remains unacceptably high at 9%.  With wage growth showing little sign of acceleration and core inflation at a mere 1.1%, there appears little to threaten their inflation targets near term. As a result, I expect the ECB will reduce its monthly purchases to Euro30 billion for 9 months in January 2018 with the aim of exiting the program towards the end of the year. (Under this scenario, the ECB will buy at least another Euro 270 billion compared to the consensus of 150 bn).

At its September meeting, the ECB addressed how the Euro’s sharp appreciation may influence monetary policy.   As Chart 2 illustrates, the Euro is only now approaching fair value. Indeed, the currency may still be cheap, and European exports are expanding still at a healthy 6% clip.  Moreover, while import prices have been declining lately, this reflects lower oil prices more than FX effects.  Consequently, the Euro could rise another 5-10% (which I do not expect near term) before the ECB would become overly alarmed.

When will European rates rise?  The ECB has indicated rates will remain steady until well after QE ends.  In the USA, the first rate hike occurred 14 months later. While the interval will be shorter, the first European rate hike is unlikely before H1 2019. When might the ECB consider balance sheet reductions? Again, in the USA the gap between ending net purchases and balance sheet reductions was nearly two years. In Europe, this looks like a 2020 story.  Unlike in the USA, the markets appear to believe the ECB – correctly discounting less than a 50% chance of a rate hike next year.

United Kingdom:  While the Bank of England prides itself on its transparency, the MPC surprised the market at its September meeting by hinting strongly that it would raise interest rates in November.  The BOE has some explaining to do, as they had focused previously on the adverse impact of Brexit and the weakness of consumer spending.  What is behind the shift in gears?  First of all, I believe the MPC wants to reverse the post-referendum rate cut.  In addition, Governor Carney had been frustrated by the market’s failure to correctly discount the monetary policy path the Bank was outlining – a credibility gap similar to the USA.

Governor Carney appears to have succeeded for now. The markets are now discounting a November rate hike and two further increases in 2018. That seems about right.  To be sure, above-target 3 % inflation and a tighter labour market (unemployment at 4.2%) argue for tighter policy. However, the UK economy is underperforming the G7, reflecting Brexit uncertainty, and wage pressures remain under control.  I anticipate the UK consumer will remain a headwind for the next several years.  And, inflation will peak in Q4 2017, approaching the 2% target by early 2019.  The markets, however, do appear overly sanguine over the long term. Rates are expected to peak at only 1.4%, which still is too low unless Brexit talks fall apart (which I do not expect).

Japan: This part is easy.  The Bank of Japan will be the last of the G4 central banks to exit ultra-loose monetary policies.  To be sure, the economy is improving.  However, as Chart 1 illustrates, core inflation is the lowest at 0.7%. And, with wages up a mere 0.9%, it will be years before Japanese inflation approaches its 2% goal, and the BOJ alters policy.

Emerging Markets: Delinking From the G7

 Several key emerging markets are dealing with a completely different issue. After coping with the inflationary impact of past currency collapses, how much leeway exists to reduce interest rates in an effort to address weak economic conditions?  Good investment opportunities exist.

While Russia has emerged from its deep recession, the headwinds resulting from ongoing consumer weakness and the failure to address structural issues have limited GDP gains to 1.5% during H1 2018.  With inflation (currently 3%) well below the 4% target, the CBR is likely to lower rates 200bp.

In Brazil, likewise, the inflationary impact of the prior Real weakness has now past, and the risk now is that price growth will undershoot the 4.25% goal – headline and core inflation are now at 2.5% and 3.8% respectively.  With economy limping out of the previous deep recession, interest rates have been declining sharply already.  However, another 150bp of cuts are likely prior to the election next year.

Inflation in Mexico has peaked last month.  With the peso extremely undervalued, achieving the 3% target will take time (headline now at 6.3%).  However, sluggish growth (Q2 GDP at 1.8%) points to 100bp lower rates prior to next year’s election.

Turkey is different.  The economy has recovered sharply after the lira’s sharp depreciation – Q2 GDP advanced 5%. As a result, the inflation shock will be more persistent: Prices are rising 11% compared to the 5% long term target. Further monetary policy tightening likely will be need, especially if the currency weakens further, as I expect.

Strategic Implications

  • US monetary policy has been a neutral factor in the recent surge in US equities. As the P/E ratio has remained relatively stable during the past three years, rising US corporate earnings have been the key driver of record-setting market performance.  As the market is not properly discounting the Fed’s future decisions, monetary policy will become a negative influence in the year ahead.
  • More aggressive US monetary policy relative to other G7 nations and the Fed’s credibility gap (which does not exist elsewhere) point to an underperformance of US equities and bonds compared to Europe and Japan.  However, a major market correction (10%) will occur only when other central G3 central banks begin to tighten policy. US 10-year yields will move towards 2.75%.
  • Likewise, the same combination will support the US dollar. We target $/Euro 1.12 and Yen/$ 120.
  • As the BOJ will be the last to act, the yen will also weaken compared to the Euro. As the markets are now discounting properly upcoming Bank of England decisions, higher UK interest rates will not prevent sterling weakness: target $/£1.25.
  • I believe US equities are only discounting about a 30% probability of US tax reform. A major program could propel the S&P to 2700, but failure would lead to 2450.  I expect the plan will take time and be quite limited; thus, I expect small single-digit US returns ahead.
  • Falling inflation creates good investment opportunities in Emerging Markets, especially Russia, Brazil, and Mexico. The undervalued MXN will outperform, BRL and TRY will weaken