On the QT

2009 saw the world embark on a giant economic experiment – that of Quantitative Easing (QE) in which Central Banks injected large amounts of money into their financial systems. Next month, the Federal Reserve announced this week, will see a new first for monetary policy – a policy of Quantitative Tightening (QT) in which money will be withdrawn from the financial system.
They have announced that this new policy will be phased in, starting at a rate of $10bn per month from October, rising each quarter to $50bn per month by October 2018. At the same time, they expect to raise interest rate four more times to 2% by the end of 2018.
The timing of this policy shift appears less related to current economic conditions and much more to two other factors. First is that Western Central Banks appear, as a group, to have decided that the very easy monetary policies need to be pulled back. In addition to the Federal Reserve, the Bank of England has also recently indicated its desire to increase interest rates and the ECB is has laid out plans to bring to an end its QE programme. This tightening seems to be globally co-ordinated. Secondly, the Federal Reserve appears to be publicly setting out its policy for the next year, in such a way that it would be embarrassing not to carry it through. This comes at exactly the time that there are many places on the Federal Reserve Board to be filled over the next twelve months by nominees of President Trump, including the key role of Chairman currently filled by Janet Yellen.
Over the period of QE, from October 2008 to October 2014, the Federal Reserve increased its balance sheet from about $750bn to $4.5 trillion through 3 separate programmes of purchases. Its peak purchase rate was $85bn per month.
The widely accepted effects of the QE policy were:
1. It helped to offset the effects of the Global Financial Crisis in 2008/9, and prevented a 1930s style Depression from setting in.
2. It has done little to foster a rapid economic recovery, instead US GDP growth has stabilised at a muted 2% pa rate, only a little higher than the increase in population, and inflation has struggled to exceed 2%. There is little evidence that the increased money supply has found its way into the real economy through physical investment.
3. The prices of financial have moved much higher, principally through higher valuations relative to the income streams they produce. This is evident in house prices, stock prices, bond prices and the prices of prestige assets such as artwork and vintage cars. The increased money supply has thus remained within the financial economy rather than the real economy.
4. The combination of lacklustre real economic growth, rapid growth in financial asset prices, and the skewed distribution of wealth in the US economy has meant that the very wealthiest in 2008 have become even more wealthy and inequality has risen very substantially with the richest 0.1% gaining much more than the richest 1%, who gained much more than the richest 10% who gained much more than the rest of the population.
The implications of QT are thus that what has been to be a key support for financial market prices will be reversed by falling valuations as money is withdrawn from the financial system. It may also be that in fact this has a limited impact on the real economy as the decline in wealth will affect only the very wealthiest in society who demonstrate a low correlation between changes in their wealth and changes in their spending patterns.
A deeper concern is that QT will affect valuations in both equity and bond markets at the same time. Most investors have not seen an environment in which both markets fall simultaneously and this has the potential for aggressive selling of leveraged positions in markets, which could take markets down to surprisingly low levels.

Debt without Growth

Much has been made of the fact that the last seven years have seen one of the weakest economic recoveries from recession on record. Not only has real growth been relatively low in this recovery but inflation has also remained consistently low. The two together comprise nominal (or money) GDP, which is the growth rate of the economy in actual money terms, and is what businesses and consumers experience directly. In the UK real growth of 1.5-2.0% is coinciding with inflation of near zero, so that nominal growth has been less than 2%. This compares with typical nominal growth rates of 5-6% before 2007.

This appears to be following a worryingly similar pattern to the Japanese economy which since the early 1990s has seen average real growth of about 1% and inflation of minus 1% giving zero nominal growth over the last twenty-plus years. Such stagnant nominal economic growth, if it goes on too long, affects expectations about the economy. When companies and households expect no or very little nominal growth, they lose confidence in future economic opportunities and do not seek to invest to benefit from such growth or seek to spend since there is a fair chance that purchasing anything will be cheaper in the future and they have little confidence that their revenues or pay are likely to rise in the future.

In such conditions debt becomes a huge burden as it is a fixed nominal sum. If it was taken on with expectations of nominal growth of 5% per annum, but in fact there is very little nominal growth, the cash flow to service the debt is harder to find. The rational behaviour of economic agents is thus to save and pay down debt, further constraining the level of demand in the economy and creating a negative feedback loop.

This process terrifies central bankers for while they all know how to get inflation to fall if it is too high, they do not possess safe tools to get inflation to rise when it is too low. Thus we have been in a world of first low interest rates, then zero interest rates and now negative interest rates and several rounds of QE where money has been pushed into the financial system. By and large these have failed to get inflation rising again though financial market assets have seen price inflation. Since the Global Financial Crisis, government deficits have continued to lead to more debt being issued while companies have also increased debt, not to invest productively but in order to buy back equity. Debt has continued to grow but economies have not kept up

There are only three ways to get rid of any debt burden – Deflate, Default or Devalue. “Deflate” means to spend less than your income to provide the savings to repay the debt – this is fine for individual borrowers, but troublesome for the economy when pursued by governments or many borrowers at the same time. “Default” means not repaying – a terrible solution for the lenders who will reduce their own spending to compensate and also become far less keen to lend again in the future. Since the first two are very unattractive options to policymakers, their preference is usually for “Devalue”. This means apparently repaying the debt but doing so with money that has far less value. There are two routes to achieving this, first (for governments) by letting your currency fall on the foreign exchanges and second by creating inflation so that the real value of the debt repayment is much less. A good way to achieve both routes is to create a lot more supply of your own currency.

So the global economy finds itself in a real bind – weak growth has meant that the debt burden has increased and this has ensured that weak growth will continue. Policymakers have so far been unable to break free of this cycle.

For investors, the key actions are to be prepared for continued low growth and low inflation – which means low returns from all asset classes – until such time as policymakers panic and decide to get serious about creating inflation to devalue the global debt burden. At that point bonds and cash will lose a lot of real value and gold will find itself in massive demand as the inflation hedge and the only currency that politicians cannot create at their discretion.

Peter Pan, Central Banks and markets

J M Barrie’s Peter Pan had a very strong grasp of the necessity of faith – “Whenever a child says “I don’t believe in fairies”, there’s a fairy somewhere that falls down dead” was written in 1911, and his own ability to fly was critically dependent on his lack of doubt that he could fly.

Ever since the introduction of QE in 2009, markets have had faith that the unconventional actions of the Central Banks would lead to economic recovery. The markets’ expectation of better times ahead itself played a key role in boosting confidence in the real economy, so helping to generate that recovery.

In the last three months however, that faith has been eroding as markets have come to believe that central banks are no longer in control of events. In Japan, the failure to boost QE further at the end of 2014, when the Bank of Japan were expected to do so, closely followed by the adoption of negative interest rates a week after denying they would do so looks like panic. In Europe, Draghi encouraged markets to believe that further ECB easing would be forthcoming in December, only to be unable to deliver it, and then repeated the encouragement that action would be taken in March after market weakness in January. The ECB appears to be a very divided Central Bank. In the US, the Federal Reserve clearly indicated in December when it raised interest rates for the first time in seven years that it expected four further such increases in 2016. Yet markets now assign an equal probability to their next move being a rate cut as a rate hike – the Fed is losing credibility.

Behind all this is the continued deterioration in growth expectations – a year ago there was a general sense that 2015 would see economic recovery around the world as the enormous global monetary easing over the previous six years finally bore fruit. The reality was that once again growth disappointed expectations even with the tailwind of a much lower oil price. Market sentiment is giving up on monetary policy producing economic recovery, and their lack of belief will make it even harder for Central Banks to deliver it.

In particular the move to negative interest rates in Europe and Japan, and the admission by Janet Yellen that the Federal Reserve would also do so if they believed it was necessary has alarmed investors in bank securities, both equities and bonds. Coming as it does with further downgrades to global growth expectations, markets have drawn the implication that central banks themselves are losing confidence that further QE will stimulate economies and thus they are moving towards the idea of negative interest rates. If the Central Banks no longer believe in QE, why should anyone else?

Widespread negative interest rates have not been adopted before – perhaps they will incentivise people to spend rather than save, but that is unclear. What is clear is that negative interest rates are bad news for banks – they have been very reluctant to extend negative interest rates to most depositors, with the result that their net interest margins are falling, at a time when loan growth is slow or non-existent. Banks are the worst performing equity sector so far in 2016.

Markets have now lost faith in the ability of Central Banks to create economic growth – falling bond yields and falling equity prices demonstrate this. To recapture that faith, Central Banks will have to take even more aggressive, unusual and unexpected action.

Homogenised bulls

Using peer pressure to create a stockmarket rally

Currency-adjusted, Japan is the best-performing major stock market so far this year. This has continued the uptrend that began in late October of last year, a move that started with the announcement of an increase in QE from the Bank of Japan. This is the second phase of the Japanese equity bull market that was kick-started by Abe’s election victory and the introduction of Abenomics in late 2012.

That first phase saw shares rally as the currency fell sharply, government spending was boosted and an aggressive QE policy from the central bank. For the most part it was driven by foreign investors who were quick to understand the reflationary impact of these policies and their impact on corporate earnings. Japanese domestic investors were not major buyers during this phase of the market. Then from May 2013 to November 2014, the market consolidated the very substantial gains made in the prior six months.

Over those eighteen months, a number of key, interlinked, institutional changes were, however, implemented in Japan as part of Abe’s “third arrow” of structural reforms. Two of these have been crucial for the stock market and both rely heavily on the Asian concept of “face” and the strong Japanese desire not to be seen as out of line with the rest of society.

The first change has been to assert control of the Government Pension Insurance Fund (the GPIF). By insisting that it take notice of the Bank of Japan’s new inflation target of 2% and the effects of the QE programme aimed at generating that inflation and by replacing the previous chairman, the government has forced the GPIF to reconsider its strategic asset allocation, which was heavily biased to Japanese Government Bonds with negligible yields, towards much higher weightings of Japanese shares and international securities. As the leading pension fund in the country, the actions of the GPIF are carefully monitored by the other pension and investment funds in Japan and then copied, as is typical in the Japanese culture.

The second change has been the introduction of a new stockmarket index, the JPX Nikkei 400, which the GPIF is using as its benchmark for the domestic Japanese equity mandates that it is awarding as part of its move towards greater equity exposure. Membership of this index is not solely determined by market capitalisation, but also by companies’ success in implementing good standards of corporate governance together with operating profitability and, most crucially, corporate return on equity – which for shareholders is possibly the critical measure of profitability. For companies that would normally expect to be included in any list of the top 400 Japanese companies, the discovery that they do not qualify for this index has become a mark of shame.

After decades of keeping shareholder interests a long way down the pecking order of corporate priorities, the introduction of this index, and its use by the leading investor in the country, has finally produced a change in corporate mindset. For example, Amada, a leading Japanese toolmaker, was mortified to find itself excluded from the index last summer. It has recently announced that for the next two years it will pay out half of its net profits as dividends, use the other half to buy back shares and hire two independent non-executive directors by the middle of next year.

The result of these changes is a dramatic re-allocation towards equities by Japanese institutional investors – this is most likely to be seen in the new financial year which has just begun (April 1). For the first time in a generation Japanese investors are likely to become significant net buyers of Japanese shares. Simultaneously, Japanese companies finally have a good reason to be far more shareholder friendly, to make profits, to declare them as such and to reward their shareholders with dividends from those profits. This is the path trodden by many US companies over the last five years and has been very rewarding for shareholders there. It may finally be time for shareholders in Japan to enjoy the same experience.

Forgive us our debts!

An open letter to Messrs. Osborne and Balls

Dear George and Ed,

Are you seeking a policy that you can surprise markets with on the first day after the General Election, just as Gordon Brown managed when he made the Bank of England independent in 1997, that you cannot talk about ahead of the election, but has no cost and will probably boost your chances of winning the 2020 election?

Well here it is – tell the Bank of England to cancel all the government bonds it has bought through its QE policy intervention in financial markets. I am sure your advisers have already produced papers looking into this for you. Obviously if one of you announces it before the election, the other will denounce it as dangerous and totally irresponsible but I think it works for whichever of you is Chancellor in May.

The Bank of England bought £375bn of gilts in their quest to support the UK economy between 2009 and 2012, which represents about 25% of the total gilts outstanding and about 23% of UK GDP. Since the Bank of England is an arm of the UK government (though acts independently when setting monetary policy) then these gilts represent debt that the UK owes to itself – each year the government pays interest on these gilts to the Bank of England, which books the interest as income and can be used to pay a dividend back to the government. On the national balance sheet, the gilts are an asset of the Bank of England but a liability of the government, and so cancel each other out. Although when QE was originally announced in 2009, it was expected to be temporary and would be unwound (ie the gilts sold back into the secondary market) when policy was to be tightened again, it is now clear that this remains a long way away and policy tightening will initially be implemented through interest rate increases. These gilts will be held for a long time.

The advantage to you in cancelling these gilts is that the ratio of debt to GDP falls from around 90% of GDP to around 70% of GDP and the UK balance sheet suddenly looks much healthier in absolute terms and compared with the major European countries as well as the US and Japan. The pressure from being an economy with too much debt disappears and gives you as politicians much more flexibility in how rapidly you need to deal with the debt. Further, ahead of the 2020 election you will have lots of very attractive charts showing that the UK has much less debt than all those around – what a sound economy the UK will seem to be!

What are the downsides? – well, the Bank of England will technically be bankrupt since the value of the bulk of its assets fall to zero, but that doesn’t matter because it can then print the money it needs to rebuild its capital base. This will enable to others to say that it represents pure money printing on a permanent basis, which may be argued to be hugely inflationary and risky. But this has been the case for almost 6 years now with QE and there are still no signs of these inflationary risks – all that is happening is that the pretence that QE will be reversed has been taken away. Also it does rather suggest that the Bank of England is not actually independent of the government – however, since the financial crisis it is very clear that governments and central banks around the world have been working together rather than independently of each other – central bank independence is a convenient illusion.

A bold act to start the next government which costs nothing to implement and provides lots of advantages to you ahead of the next election – what’s not to like?

Kind regards,

Jeremy

The German dilemma

Within the Eurozone, Germany is coming under increasing pressure to approve and adopt policies designed to stimulate the Eurozone economy. This is because (i) Germany is the largest economy in the Eurozone, (ii) since the global financial crisis, Germany has enjoyed the strongest performance within the Eurozone based mainly on exports, which has led to a very substantial trade surplus, (iii) German public finances are in a very healthy state compared with most in the Eurozone and (iv) they are rich and have the policy flexibility to act.

Many in the rest of Europe are calling on the German government to launch a large debt-financed fiscal boost through public investment spending, creating, it is hoped, jobs and demand throughout the Eurozone. The Germans are resisting this strongly because they have worked very hard in recent years to get their government finances back onto a solid footing, and are expected to get close to a balanced budget in 2014. German politicians are stoutly resisting European calls for them to spend more and move back into deficit.

It is though in monetary policy where the greater controversy is being generated. Through his public utterances over the last six months, Mario Draghi has sought, to maintain market confidence by positioning the ECB as about to introduce a US- or UK-style QE programme in its efforts to boost demand and inflation. However the actual policy steps agreed at ECB meetings have not lived up his words – QE is always just a few months away. It is clear that, behind the scenes, the Bundesbank and several ECB members are fiercely opposed to such a policy, with many in Germany believing it to be illegal. They are angry at the way that Draghi has sought to bounce them into such a policy by his public statements.

To many in Europe (and indeed the world), the Germans are the bad guys, doggedly blocking any moves to boost the moribund Eurozone economy due to their particular economic ideological fixations around sound government finances, conservative monetary policy and a strong currency. Being so out of step with their Western allies is not a position in which post-war German governments have wished to find themselves, and in any other field than economic policy, they would have made adjustments to their position and found a compromise.

It should however be recalled that Germany never asked for the single currency, and when it became inevitable, did their best to restrict membership only to those economies that were happy to embrace German economic orthodoxies, for precisely the reasons that are now being played out within the Eurozone.

In 1990, Mitterand’s price for accepting the re-unification of Germany was monetary union. In permitting Germany to become a much larger, and thus more powerful nation, he sought to maintain France’s significance by sharing the all-powerful Deutschemark. Kohl accepted this provided that all those involved in monetary union were prepared to manage their economies according to German orthodoxy. Thus the ECB’s mandate was constructed along very similar lines to that of the Bundesbank – very independent of politicians, with a mandate of low inflation delivered through conservative monetary policy. Similarly, the Maastricht Treaty constrained the size of government deficits and public debt that individual countries would be permitted. With these in place, the only economic solution for countries finding themselves in economic difficulties is for export-led growth, with the private sector becoming more competitive in global markets through cost control, innovation and structural reform. There would be no room for short-tem fixes generated by lower interest rates, weaker currencies and debt-financed government spending.

The criteria for membership of the euro were deliberately designed to exclude what are now known as the peripheral economies. Only the “core” European economies were expected to qualify, who understood and were prepared to accept German economic thinking. However everyone wanted to qualify and through a combination of the long economic boom of the 1990s and some very creative accounting, the euro began life both with many more members than Germany had ever intended, and with much weaker (though disguised) public finances than Germany would have countenanced.

Since 2008, the Germans have continued to espouse the policies that they believe were written into the monetary union. Thus they expect countries to embrace public sector austerity to reduce budget deficits and bring their giddy debt levels back under control, they expect their Central Bank to adhere to policies of sound money by control of money supply growth and they have a particular fear of Central Banks who buy government debt with newly-printed money. This is the economic and monetary union Germany insisted on, signed up to and has always believed that others had agreed to.

To date they have not relented on these principles, but it is leading to great pain and bad will across Europe, where the peripheral economies which previously resorted to policies of devaluation and government spending to boost their economies in times of trouble, cannot understand why these should not be adopted now. Germany now faces its greatest dilemma – whether to abandon the economic principles which have been the foundation of its economic success since 1945 and remain on good terms with the rest of Europe, or, remain true to its economic ideals and be the cause of the break-up of the monetary union as weaker economies are forced to leave.

In 2012, Angela Merkel opted to bail out Greece rather than risk the break-up of the euro, though by all accounts the decision was close and arrived at only after months of consideration. When the ECB finally votes to adopt QE (almost certainly sometime in early 2015), there will be vigorous opposition within Germany including legal challenges. Once again Mrs Merkel’s leadership will be key in determining the future for Germany and for Europe.

QE: Farewell or Au Revoir?

The US policy of Quantitative Easing (“QE”) is due to end later this year. Growing uncertainty about the evolution of monetary policy as the economy strengthens is likely to contribute to increased market volatility. Should QE be bade “Farewell” with the economy strengthening, this will mean a less accommodative monetary policy with negative consequences for markets; should it end with the economy weakening, it is more likely that this will prove to be merely “Au Revoir” for QE as it remains the only policy tool available to stimulate a weak US economy. In either case, a period of increased market volatility is likely, and portfolios should therefore remain light in US equities.

The Federal Reserve (“the Fed”) expect to complete their QE programme by 31 October 2014, after 6 years and a $3 trillion increase in the Fed’s balance sheet. The original rationale for introducing QE was to extend the scope of monetary policy after interest rates had fallen to near zero. One of its anticipated advantages was to raise the demand for, and thus the price of, securities in the financial markets. This had the benefit of increasing general economic confidence, as well as reducing the cost of capital for companies who would then be better able to boost capital spending. Forcing liquidity into the financial markets was therefore expected to boost the real economy.

Since February 2009, QE has created a substantial bull market in most financial assets: in Dollar terms, US equities have risen by almost 200%, and global equities by 150%; in addition, yields on all types of bonds have declined to historic lows during this time. The QE programme has taken US financial markets to high levels of valuation, as this injection of liquidity into the financial system has sought to find a home.

Looking back at market movements in recent years, the stock market moved steadily upwards during each phase of QE, but tended to be much more volatile when QE was not the Fed’s declared policy (in mid-2010 and from mid-2011 to mid-2012) .  Alongside lower bond yields, equity markets have become much more expensive during the phase of QE. QE has been a supportive factor for the US stock market, and we have noted previously that most of the rise in global equity markets in recent years is accounted for by rising valuations rather than rising earnings.

The effect on the real economy is less clear. Bank lending to US companies has risen, but little of that lending has been spent on capital investment. Instead, additional lending has funded large share buyback programmes and merger and acquisition activity by US companies. Both of these activities boost demand for shares in the stock market but do little for growth prospects in the real economy.

QE1 was very effective in stabilising the market for a number of credit instruments and economic growth rose from -4% to +3% while it was in operation. Since then growth has remained between 1.5% and 3% despite QE2 and the far larger programme of QE3, which have both been conducted in the face of muted economic growth. This level of growth has been disappointing when compared with a normal level of growth of 3% or more since the 1980s, and typically much faster rates of growth when recovering from recessions.

It is interesting to note that both QE2 and QE3 were initiated at about the same time as economic growth began to slow. This indicates that (i) the Federal Reserve has a low tolerance for a weaker economy, and (ii) with interest rates already at zero, if they fear a weaker economy, their only response has been a new and larger QE programme. It is likely that markets would interpret any re-introduction of QE as a major failure for the Fed.

The recent decision to bring QE to an end by October 2014 was based on the Fed’s forecast that growth will rebound to 3% from the second quarter and stay there for the next few years. However, the US economy has only managed a 3% year on year growth rate in three quarters since 2008, so this would require a substantially healthier economic performance than has been seen for some time. It is quite feasible that the economy will weaken again once QE has come to a halt, in which case the Fed may feel obliged to restore a QE programme since there are no other obvious policy options. This would be seen as very negative by markets as it would highlight the US economy’s lack of ability to grow without extraordinary policy action.

The introduction of QE was a new experiment in monetary policy when introduced, with no one really understanding how and whether it would work and the size of the programmes that would be necessary. Equally, ending QE (and at some point, reversing QE) will also be experimental, and the effects on markets and the economy are unknown. The experience of Japan early this century, and the two short-lived attempts to end QE in the US in the last few years, has been that markets react negatively to an early withdrawal of liquidity, and that this damages confidence and sentiment in the wider economy. The Fed is hoping that economic recovery is (i) more firmly established than the current GDP data imply, and (ii) able to withstand the negative effects of less demand for market securities from QE. The current trajectory of unemployment suggests that the US economy is indeed self-sustaining and, to date, QE has been wound down without adverse consequences. However, if the withdrawal of QE does stall the recovery then it will be very difficult to kick-start the economy again, since the Fed will be left with few policy options other than renewed and magnified QE.

Throughout 2014, we have been expecting (i) more muted returns from markets than we saw in 2013, on account of this change in policy by the Fed, and (ii) greater volatility in market prices as QE was tapered and then eliminated.   Market returns have certainly been more muted so far in 2014 but they have adapted to the tapering of QE without a rise in volatility. However, the looming prospects of tightening monetary policy and rising interest rates, though positive for the Dollar, are likely to cause problems for US equities, and we remain light in US equities across our portfolios.

ECONOMIC AND MARKETS OUTLOOK FOR 2014

Economic outlook

Five years on from interest rates being cut to almost zero in most Western economies, and the introduction of QE programmes in the US, UK and Japan, the global economy finally seems to be moving onto a more secure footing.  Risks remain though, particularly the high levels of government and consumer debt in most Western economies, which remain a constraint on future growth.  In addition, the weakness in inflation indices and continued high levels of unemployment, mean that a renewed global economic downturn, in the immediate future would be very damaging, as there would be very little policy flexibility to offset economic weakness.  Our regional views are as follows:

  • The UK economy has been recovering strongly since last spring when the Help to Buy scheme was announced.  This recovery has been led by housing and mortgage demand, rather than by the business investment that is required for a healthy and sustainable economic recovery.  However, the consumer can drive a continued recovery through 2014 and up to the 2015 election, if savings rates continue to fall.
  • The US economy has entered 2014 growing at a near 3% pace, and this is expected to continue for 2014.  As in the UK, business investment is still a problem, as companies appear far more concerned with growing dividends and buying back shares to boost their share prices than by investing for future growth.
  • The European economy is still struggling. Growth should be positive in 2014 after close to zero in 2013, but recovery will be constrained by continued austerity by most governments, negative inflation rates in many peripheral economies, and by banks still seeking to reduce their loan books ahead of the ECB’s Asset Quality Review later in 2014.
  • The Japanese economy continues to respond to Abenomics.  The increase in the National Sales Tax from 5% to 8%, which will take place in April, will mean a strong first quarter but a weak second quarter.  However, the Bank of Japan has indicated that it is ready to increase its already large QE programme to mitigate any economic weakness.
  • In Asia, Chinese growth is slowing as the  authorities there are seeking a rebalancing of growth away from the wasteful over-investment seen in recent years towards greater consumer spending.  Higher wages have been a key part of this, but this has been funnelled into property speculation rather than consumption.  The central bank is trying to deflate the housing market without deterring the consumer from spending.
  • Other emerging economies are facing problems as the improvements in growth elsewhere are impacting the flows of financial market liquidity, which have been supporting them.  Current account deficits in Brazil, Turkey and South Africa, are now causing falls in their currencies and higher interest rates in response, which will lead to weaker growth in 2014.

2014 should see the world economy move back towards a more normal pace of growth.  For central banks, the dilemma is when to move back to more normal settings for monetary policy.  We believe that official interest rates are unlikely to rise in the West during 2014, as it is likely that central banks will err on the side of risking creating inflation rather than risking creating more unemployment.

Markets outlook

Entering 2014, the consensus amongst most investors on the prospects for the global economy and for stock markets in 2014 is one of greater optimism than for several years.    However the two factors of improved economic prospects and stronger financial markets, do not necessarily occur simultaneously.  Indeed, stronger economic growth has already led to the Fed tapering its QE programme, and investors bringing forward their expectations of when interest rates will begin to rise.  Typically, the financial markets perform well in expectation of improved growth, but when that growth appears, the liquidity in the financial markets is then needed by the real economy for investment.  This tends to mean rising bond yields and falling P/E ratios, and subdued investment returns.

For the UK markets in particular, the domestic pension funds have experienced a significant improvement in their funding position from the combination of rising equity prices and rising bond yields. Many schemes are being advised by their actuaries to take advantage of this improvement and to “de-risk” their portfolios by reducing equities and buying index-linked bonds.

Within bond markets, we are not particularly hopeful of much in the way of returns in 2014, and hold UK index-linked bonds for their favourable tax treatment, and the option they provide should UK inflation expectations increase.  Emerging market government bonds issued in US dollars now offer attractive yields for the level of credit risk that they bring (such as those witnessed in the recent poor economic developments in Turkey and Argentina).

We favour UK commercial property, where we believe that the market cycled has reversed from falling rents and capital values to one where rents and capital values are rising.  The yields on commercial property are also attractive compared with those available on bonds and equities.

Within equity markets, we favour: (i) Japan, but with the yen exposure hedged, as the Bank of Japan will continue to print money until economic recovery and inflation appear well-set; (ii) UK smaller companies, which for many years have not delivered the extra performance over large and medium-sized companies normally achieved from such investments – the current strength we are witnessing in the UK domestic economy should be reflected in better performance from smaller companies;  and (iii) Asia, where valuations are historically below average in absolute terms and long term growth prospects remain strong.  We have a neutral view on the larger companies in the UK equity market, with valuations on the FTSE100 Index near their long term averages.  The market would benefit from weakness in the pound, as profits in the second half of 2013 have been hurt by the strength of Sterling against the Dollar, Euro and Yen.  We expect the Dollar to be the strongest currency in 2014, but would expect a stronger Pound against the  Euro and Yen.

We are more cautious on the US and European equity markets.  In the US, corporate earnings expectations are already very high, and the valuations on those expectations are also at historically high levels, so strong performance from US equities will be difficult to achieve.  In Europe, in addition to high expectations of earnings growth and above-average valuations, as in the US, the growth outlook also remains subdued, bringing an extra degree of risk to European share prices.

We expect equities to outperform bonds during 2014, as they did in 2013 but expect the year to be both less profitable and more volatile for investors.

 

The Global Monetary Policy Kaleidoscope

In 2009, in the face of a global economic crisis, the major economies of the world came together and acted in concert to ease monetary policy aggressively.  Together with fiscal stimulus in the US and China, these policies helped to prevent the world from slipping into depression.  Four years on, the economic conditions around the world vary enormously, and the appropriate monetary policies are now very different (though for all countries fiscal restraint is deemed necessary).  These differing monetary policies are producing clear differences in how the local financial markets are performing, and in 2013 there has been a much greater dispersion of performance between equity markets around the world than in 2012.

The economy with the most aggressively easy monetary policy (relative to the size of its economy)  is currently Japan, where in response to the lead of the new Prime Minister, the new Bank of Japan Governor has begun a programme of doubling the country’s monetary base in just two years.  This is being done deliberately to raise the rate of inflation in Japan from the negative rates seen in recent years to the new target of 2%.  To bring Japan out of its 20 year deflation, policymakers have articulated that inflation, and inflation expectations, need to rise to boost the nominal growth rate of the economy.  Should the current policy settings not be sufficient to do this, it is expected that policymakers will move monetary policy to an even easier stance.  The weaker yen that is likely from this policy should be instrumental in helping to boost inflation.

Next is the US, where currently the QE programme is about $4bn of new money creation every day that the financial markets are open.  Before the latest Japanese policy move, this constituted the most aggressive monetary easing.  However, the recent furore following Bernanke’s comments about the tapering of the QE policy indicate the sensitivity of markets to changes in the direction of US monetary policy.  Bernanke tried to argue that tapering a policy of printing $4bn every day to one of printing $2bn or $3bn was still a very accommodative policy; the markets however appeared to interpret it as a tightening of policy.  The rise in US bond yields since May shows that a policy that is easy, but less easy than it was, creates different expectations in the minds of investors, and the Federal Reserve’s words have thus changed the thinking of investors.

Both the ECB and the Bank of England are at a similar phase in their monetary policy.  Both have pursued unconventional policies in the past, the ECB with their three year LTROs and the Bank of England with their own QE programme, but have done little recently to move policy easier.  However, the new Bank of England Governor has clearly been tasked with boosting economic growth in the lead-up to the next election, and the ECB is concerned about the continued poor performance of the Eurozone economy.   The recent rise in bond yields that began in the US and spread across the Atlantic has been unwelcome as it raises the cost of borrowing for business and so offsets the otherwise easy policy in both the UK and the Eurozone.  A further easing of monetary policy can therefore be expected from both Central Banks, and crucially, for markets, the direction of monetary policy is still moving easier, in contrast to the US.

In China, markets have been surprised by the actions of the People’s Bank of China in not providing sufficient liquidity for the interbank market to operate smoothly in the face of liquidity pressures.  This caused overnight interest rates briefly to move above 10%, and has been interpreted as a lesson to the banking system that they have been too carefree with their lending and need to cut back.  This is effectively an act of policy tightening, though it is unlikely that the Chinese will take such tightening too far and seriously damage the economy’s growth prospects.

Finally, there are a number of significant emerging markets such as Brazil, Turkey, Indonesia and India where Central Banks have actually raised interest rates or have indicated an intention to do.  For the most part, this has been due to currency weakness, which boosts inflationary pressures in these economies, and so a tightening of monetary policy is believed to be required, in contrast to most of the rest of the world.

The league table of the stance of monetary policy, which runs from Japan, the US, the UK, Europe, China and Asia and then other emerging markets correlates precisely with the league table of year-to-date equity market performance.  Those countries with the easiest stance of monetary policy are those whose stock markets have performed best, and those with the tightest policy stance have performed worst.  This highlights the increasing dependence of financial markets on the liquidity provided by Central Banks, rather than fundamental economic and earnings trends.

Looking forward, we would expect Japan to remain at the top of the easy monetary league, with the UK moving up and the US moving down in the next few months, and the Eurozone having little room to make any changes.  China’s slowing growth will eventually produce an easier monetary policy, but may not be imminent, while the other emerging markets appear to be the furthest away from easier policy.  Japan and Asia remain the most favoured markets in our portfolios with Europe and Emerging Markets the least favoured.

Fed up – down with QE?

Ben Bernanke’s discussion of the Fed’s policy intentions in the press conference following the Federal Reserve meeting on June 19 was a shock to markets, with all asset classes around the world falling sharply in response.  His remarks, together with the Fed’s revised economic forecasts for the US, indicate that the policy of QE will begin to be reduced when the unemployment rate falls below 7.5%, and would be stopped altogether when the unemployment rate falls below 7.0%.  Interest rates would only begin to be increased when the unemployment falls below 6.5%.  On the Fed’s economic forecasts, QE would begin to be tapered in September, and end by next summer, with interest rates beginning to be increased in 2015.

Financial markets were very surprised, and for five reasons as follows: (i) the Fed’s latest economic forecasts are optimistic regarding growth and inflation over the next eighteen months  – the Fed expect growth of about 3% over this period, faster than at any time since the crisis, and inflation rebounding to about 2%; (ii) the Fed’s forecasts for growth in 2013 and 2014 are lower now than they were last September when they announced the latest round of QE; (iii) Bernanke has always been very clear that the errors of US economic policy in the 1930s and Japan in the 1990s, following banking crises, lay in the authorities tightening policy too early and before the economies had fully recovered – it was thus expected that he would be slow to reverse QE; (iv) the rest of the global economy is not in a very fit state to cope with this move – Europe remains in recession, the Chinese recovery is not coming through as fast as had been expected, and Japan is just embarking on its own massive round of policy stimulus in an effort to revive its economy; and (v) Bernanke said it was significant that the total amount of QE would still be rising which  indicated easier monetary policy (i.e. lifting the foot off the accelerator) , whereas the markets focussed on the fact that it represented a change in the momentum of QE, and so see it as a tightening of monetary policy (i.e. putting the foot on the brake).

If Bernanke, and the Federal Reserve, are correct in their judgement that US economic growth is about to move higher, then future historians will judge Bernanke very well.  For over five years he has maintained near zero interest rates and extraordinary levels of money creation, which has allowed the US economy to perform better than the other developed economies.  Should the economy accelerate while coping with an ending of QE, as the Fed’s forecasts imply, he would be seen as having exercised tremendous courage during the crisis in adopting QE and tremendous judgement in reversing course and ending QE.

In recent years however the Federal Reserve’s forecasts for growth have been consistently over-optimistic, as the pick-up in consumer and business confidence and spending, which was the objective of QE, has been very slow to materialise.  Seen in this light, discussing the Fed’s policy intentions so openly may be seen as unwise.  If the expected growth acceleration does not occur, the markets have been given an unnecessary and unpleasant surprise, which would make it even more difficult to raise confidence and spending.

There are also other interpretations of the motivation behind Bernanke’s comments.

  1. The most likely is that the behaviour of financial markets in 2013 (up until Bernanke’s comments to Congress on May 22), which saw both bond and equity markets moving steadily higher whether the economic newsflow was positive or negative.  Markets appeared to be responding not to fundamental news but to the provision of liquidity from the QE policy – a feature typical of market bubbles.  By clearly discussing the potential to reduce or end QE, the liquidity support for markets is removed, and any bubble is pricked.
  2. Bernanke’s term as Chairman of the Federal Reserve ends next January 31, and the indications are strong that he will not be seeking to continue.  It may be that he does not want to leave office with a legacy of the most extreme, loose monetary policy that the US has ever employed, and is therefore keen to begin the process of returning policy to more normal settings.
  3. The most bearish (and least likely) interpretation is that he and the Fed no longer believe that the QE policy is capable of delivering growth, but that the risks of the policy, in terms of the scale of the money creation and potential inflation, are now too great.

Some immediate market implications are clear.  Bond investors were happy to continue buying bonds all the time they believed that the Federal Reserve would also be buying them through QE.  From 2003 to 2008, the Asian Central Banks pursued a policy of reinvesting their large trade surpluses into US bonds to prevent their currencies appreciating. From 2009 to now, the Federal Reserve has taken over the role of the lead buyer of US bonds.  The Fed have clearly signalled that they believe this period is near to an end – in the absence of a forced buyer, bond yields are likely to move towards more normal levels.  It will take a much slower economy and a return to QE for bond investors to become confident enough to become buyers again.  This move to higher yields is however likely to slow growth, and lead to lower valuations for all financial assets.

We expect growth not to meet the Fed’s forecasts, and so not trigger the pace of withdrawal of QE that Bernanke set out in the press conference.  Such an outcome is likely however to create confusion and uncertainty in financial markets over the next few months, as investors seek to guess the Fed’s reactions to every piece of news. Bonds are unlikely to perform for some time, and investors should look to reduce positions. Equity markets are not expensive but the outlook for growth is not exciting, except in Japan, and investors should wait for a clearer picture of the global economy to emerge over the summer, before making any significant changes to portfolios