The long unwinding road...
The question I have been asked most frequently since the Great Recession is various takes on “Will central banks ever be able to end all of this extraordinary stimulus, and how will they get out of it?” The answer has always been the same: “Yes and cautiously”.
Of course different countries would exit at different times depending on a range of factors including GDP growth relative to potential, the pace with which large output gaps would close, the related issue of how quickly NAIRU (Non-Accelerating Inflation Rate of Unemployment) would be achieved, the resultant trend in wage inflation and the combined impact of wage increases and productivity on unit labour costs that would explain much of the outlook for core inflation.
Source: BLS, Eurostat, MIAC
The US Federal Reserve (the Fed) is the furthest through the normalisation process. Indeed, the Fed is about to embark on the third phase of normalisation. Phase one was ending quantitative easing, the second was raising interest rates and now they are about to start on balance sheet normalisation.
It has not always been a smooth process as the ‘taper tantrum’ of 2013 will attest. In fact, we have seen a mini repeat of said tantrum in the last few days as a number of other central banks have turned recently hawkish, or perhaps more appropriately for some, less dovish.
Why are central banks becoming more hawkish now? There has been much debate over the last few years about the economic cycle. Some have argued we have been in the midst of many short cycles, punctuated by moments of crisis. We believe we have been in one long cycle, in which we are now just at the point that output gaps are closing up. In that respect, we have always been believers in the eventual return of inflation.
The key risks central banks have had to balance are the risks of leaving the normalisation of monetary policy too late, and getting behind the curve, going too early and strangling the nascent economic recovery.
Right now, central banks are buoyed by the recent recovery in headline inflation that has had a beneficial impact on inflation expectations, further reducing unemployment rates and a generally widespread improvement in cyclical demand, which even if it doesn’t lead to immediate core inflation pressures, will assist in a more rapid closure of output gaps. In Europe the risk of political disruption is also diminished.
Interestingly, this is occurring at a time when there is new uncertainty in the sustainability of core inflationary pressures in the United States. Core inflation measures are currently heading lower, leading to the suggestion the Fed is making a mistake by pushing on with rate hikes and the normalisation process. We don’t believe they are. That’s because the labour market is tight and that is more than likely to lead to sufficient wage pressure (more precisely unit labour costs) to underpin core inflationary pressures.
Source: BLS and AMP Capital
Sure, there are reasons to believe the relationship between low unemployment and inflation may have weakened or indeed broken down all together. Workers have lost bargaining power as unionisation has diminished and technological change has led to job losses. But on the other hand, low productivity suggests that even low wage increase can be inflationary. We still hold out hope of a cyclical rebound in productivity, but that is yet to be seen.
There is also the risk to financial stability of a prolonged period of ultra-stimulatory monetary conditions. Most developed world central banks have voiced concerns at various stages about the risks to credit expansion and asset prices of a prolonged period of ultra-low interest rates. Indeed, after voting narrowly not to raise interest rates at its June meeting, the Bank of England followed up with fresh macro-prudential measures.
So where to from here? Central banks will remain cautious and the road to the unwinding of the extraordinary levels of stimulus will be a long one. We think the Fed continues to box on with normalisation. At this point we expect an announcement with respect to balance sheet normalisation in September, followed by another interest rate increase in December.
We haven’t changed our view on the European Central Bank. They have already taken one step towards tapering their asset purchase programme and we expect another announcement in September to be effective from the start of 2018. The Bank of Canada has also turned hawkish while the Bank of Japan remains the exception, seemingly stuck in perpetual qualitative and quantitative easing.
The Bank of England appears most at risk of a mistake. The recent election has made the Brexit process a lot more complex and uncertain. While the UK economy has come through the immediate post-Brexit period better than expected, there appears high risk that the uncertainty of post-Brexit relationships with the European Union risks undermining business confidence and economic activity generally. Furthermore, we think the recent increase in core inflation in the UK has had more to do with exchange rate weakness rather than any sign of persistent core inflationary pressures.
The key take-outs of more hawkish central banks for us is that markets have to get used to the fact that the era of relying on ever present “do whatever it takes” central banks underpinning asset prices is over.
Recent developments have also reversed the recent downward slide in bond yields. Bond market investors are still in a tug-of-war between normalization forces pushing rates higher versus residual perceptions of central bank largesse given low current inflation holding rates down. However, the bond market weakness in the last week shows how sentiment can turn bearish very rapidly and with little warning. For instance, the yield on the UK 10-year government bond has jumped from 1.04% to 1.26% in a single week, while that of the German 10-year bond was up from 0.26% to 0.47% over the last five days.
In such an environment, as market perceptions appear to be shifting toward mild hawkishness and traders are less inclined to ‘fight the Fed’, we remain comfortable with holding a significantly higher-than-normal allocation to cash for now. The recent jump in yields may not persist or accelerate, but the chorus of central bank officials taking a somewhat firmer line on monetary normalization (Japan being an exception) suggests the balance of risks has changed. Investors should be alert to further possible ‘withdrawal symptoms’ from a decade of extraordinary monetary support.
We recently reduced our exposure to developed market equities, reflecting rich valuations and a likely more volatile period ahead. We are not negative on the outlook for equities, but thought it prudent to take some profit and reduce our exposure to neutral. That leaves our biggest position in the income side of the portfolio as underweight bonds and overweight cash, reflecting the expectations of higher interest rates ahead.
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