Central bankers to go easy on any upsets
Equities to benefit from growth, still-low interest rates
Please note that this article can contain technical language. For this reason, it is not recommended to readers without professional investment experience.
Central bankers are or soon will have been meeting for the final 2017 policy gatherings, but their decisions are unlikely to derail the upward trajectory that financial markets – equity markets, in particular – have been on this year. With – at best – gradual policy tightening on the 2018 timetable for only a couple of the leading monetary authorities, it does not look unreasonable to expect the good times to roll on.
Having said that, equity markets were generally flat this past week, in part as participants hold their breath ahead of the central bank meetings, in part as they adopt a cautious stance heading into the year-end with a view to consolidating gains that for the MSCI World index now stand at almost 19%, at nearly 9% for Europe’s Euro STOXX, at almost 21% for the US S&P 500, and at more than 21% for Japan’s Nikkei index.* Bond markets showed equally little movement over the week.
BOJ: ETF PURCHASES LEND A HELPING HAND
Looking at the individual markets in that inverse order – Japan, US and eurozone – it is fair to say that Japan is benefitting from the global, cyclical upswing, posting third-quarter GDP growth of 2.5% after 1.4% in the second quarter, marking the best GDP growth in a decade. Net exports saw a big boost despite a 3% gain in the Japanese yen, but to say that these and other fundamentals are driving the stock market is perhaps a stretch.
Data show that Bank of Japan purchases have heavily outpaced foreign investor purchases of Japanese equities, putting a prop under the stock market, but also suggesting that there is little support from the fundamentals, however positive they have been. The BoJ, in other words, appears to be underpinning the stock market as well as the broader economy, the latter through an ultra-loose monetary policy that includes asset purchases beyond exchange-traded funds (ETFs) and that it is likely to last for the foreseeable future.
That BoJ stance should help sustain the Goldilocks label –representing a climate of solid economic growth and low inflation – for the Japanese economy and in that respect, Japan enjoys the economic conditions also gracing other global economies.
FED: STEADY AS SHE GOES
The US Federal Reserve, at this week’s policy meeting, looks equally unlikely to upset the apple cart. Indeed, it will likely raise the range for the fed funds policy rate by 25bp this week, but this is widely expected in the markets and recent data have effectively done nothing to dissuade the Fed from such action. The latest job market echoed those of many recent months, showing broad-based payrolls growth as the US economy continues to benefit from a weaker US dollar and strong global growth. The report also rung familiar as the numbers on wage growth disappointed again with further confirmation of wages moving sideways.
The search for an explanation continues, but readings such as this – combined with still-modest inflation and a low unemployment rate – are why we are likely to see the policy-setting FOMC trim its projection for the neutral ‘non-accelerating rate of unemployment’ (NAIRU), signalling that the point at which a tight labour market will start causing inflation might be further away than previously thought. Still, the FOMC might nudge up its growth forecast for 2018. That, in combination with some improvement in inflation readings, could be enough for the Fed to signal an additional 25bp of tightening next year, compared to its September forecast of three rate rises in 2018.
Even this would not necessarily jar markets, given the countervailing forces of stronger economic growth and continued company earnings next year. Further market support could come from the US tax cut plans progressing towards enactment as the House of Representatives and Senate work to align their versions of the tax reform legislation, with a final bill coming up for a vote and then the president signing it into law, possibly still this year or otherwise early in the new year. Its final shape will then be factored into the FOMC’s projections and estimates of the effects of the tax stimulus could then result in further room for monetary policy tightening.
ECB: WATCH FOR A CHANGE IN TONE
Finally, among the G3 central banks, this week’s ECB meeting will be watched more for the tone of the governing council’s statement than for its actions since policy changes are not expected. In the context of the robust shape the eurozone economy is in, council members might call for a less dovish tone and a clearer sign on the end of asset purchases under the quantitative easing (QE) programme aimed at boosting growth and inflation.
Some council members might now take the view that the economy’s rude health is leaving scope for action – even if only verbal – and that it is time for the ECB to break the link between the need for QE and the inflation outlook. Refocusing on other policy drivers would cause the market to sit up and pay attention to such a change which could foreshadow a gradual policy shift, although actual steps continue to look a distant prospect.
BEYOND THE G3: HIGHER RATES IN TURKEY AND MEXICO
Looking beyond the G3, the Turkish central bank might raise rates, in part to defend the lira and even tackle inflation and unanchored inflation expectations, while Mexico’s Banxico is expected to raise rates, in part seen as an opportunity for the new governor to cement his inflation-fighting credentials. Such moves would fit the mould in terms of inflation trends and expectations acting as policy triggers. We believe the Bank of England, however, might find it pulled the trigger on its latest rate increase too soon. We still see a chance that a worrisome outlook for growth and an accelerating fall in inflation will force it to retrace its steps and cut rates.
*data as a 8 December 2017
As for the outlook: how much inflation is too much?
SUMMARY: Global equities sold off aggressively as higher bond yields finally dented the strong January risk rally / The sell-off was triggered by strong hourly earnings data in the US, but its magnitude appears to be exacerbated by market technicals / Solid growth fundamentals and limited contagion from the equity volatility to other markets such as rates, currencies and emerging markets (EM) are consistent with a technical dislocation in markets
Why is volatility so low?
Asset allocation – September 2018
SUMMARY: US equities continued to outperform other markets such as EMU and EM equities. This partly reflects the divergence between the US economy -which is supported by fiscal expansion and a patient Federal Reserve- and relatively weaker growth in the eurozone and EM. But there is more to this divergence than faster US economic growth. The US equity rally has been led by the IT sector. This has accounted for 20%-50% of US equity returns since 2016. The rally is now looking stretched on various metrics. The other salient development in August was renewed stress in emerging markets (EM). A combination of economic stress in Turkey, weaker growth in China, Sino-US trade tensions and a stronger US dollar hurt EM assets. We believe there is value in EM assets, but the obvious circuit-breakers are still absent: a weaker USD, aggressive China stimulus and fresh Sino-US trade talks. EM assets prospects have soured and protectionism and tighter liquidity continue to cloud their longer-term prospects.