FOR INVESTMENT PROFESSIONALS ONLY
We are beginning to detect subtle changes in the attitude of central bankers to the effectiveness of their actions in driving down global interest rates. We have heard calls from the heads of the Federal Reserve (Fed), the Bank of England (BoE) and the European Central Bank (ECB) for politicians to do their bit in the effort to support economic growth and raise inflation expectations. An end to the relentless fall in yields (by end-September 2016, approximately 50% of Eurozone government bonds were negative yielding), and some direct fiscal support would have interesting implications for asset returns in the coming quarters. This would have the impact of potentially pressuring bond prices but raising the earnings outlook for cyclical and financial stocks.
The last rate cut from a major central bank came in August from the BoE in the aftermath of the shock Brexit vote. Sterling is taking the brunt of investors’ surprise at the result, having fallen by 14.4% against the dollar and 13.1% against the euro by 4th October. The BoE stepped in with an “exceptional package of measures” to support the economy in the aftermath of the vote. Unless there is another Eurozone existential crisis, we would not expect much of a sterling recovery in the near term now that Prime Minister May has started the clock on the leave process.
UK Gross Domestic Product (GDP) forecasts collapsed in the weeks after the vote, but economic releases have generally surprised to the upside since the referendum result. After an initial slide in equity markets, expectations of extended central bank accommodation, a weaker currency and the supportive economic data points have allowed UK markets to recover.
There is mounting evidence that central banks’ actions to lower rates are running up against practical constraints, that they are hurting the profitability of financial institutions, and may be encouraging excessive risk-taking. Indeed, the Fed has appeared keen to get rates higher since financial markets stabilised back in the spring. Interest rate expectations in the US have waxed and waned since then, with a succession of contradictory economic indicators.
Fed members had appeared to put a possible September rate rise on the table around the Jackson Hole symposium in late August. However, a series of weaker-than-expected economic releases in the run up to the September Federal Open Market Committee (FOMC) meeting stayed the Fed’s hand for the sixth time in 2016. At the press conference following her Jackson Hole speech, Janet Yellen said:
“…there are ways in which the response of fiscal policy to shifts in the economy could be strengthened, which would help take some burden off monetary policy.”
So what is prompting central bankers to look to politicians for help? The suppression of global yields is having effects that were certainly not intended when quantitative easing (QE) began in earnest during the global financial crisis. The ever-reducing discount rate is pushing up pension fund liabilities, resulting in companies having to divert cash that might otherwise be used for business investment into pension funds in order to plug the growing pension funding gap.
Moreover, savers who are earning little, if any return on their money, may feel the need to save even more in the current environment than they would otherwise do.This is hardly what central bankers had in mind. Increased saving is inconsistent with the increased aggregate demand that the global economy badly needs right now.
As investors are forced out the yield curve, the suppression of long rates as well as short rates has also been hurting bank profitability. Banks make money by borrowing short-term funds at a lower rate and lending those funds for longer term at a higher interest rate. The slope of the yield curve is crucial for this: the steeper the curve the better for bank profitability. The current relatively flat yield curves have come sharply into focus in recent weeks following the Bank of Japan’s (BOJ) reassessment of its policy.
On 21st September, the BOJ announced changes in its approach to monetary policy aimed at producing sustained inflation in the Japanese economy. The latest effort, dubbed “QE with Yield Curve Control”, will attempt to steepen the yield curve by holding short rates down while targeting a 10-year yield of close to 0%, (10-year yields were actually negative before the move).The change of policy was interpreted as a direct reaction to the negative effects of policy action on the banking system. Bank and insurance stocks rallied the most as the Topix gained 2.7% on the day of the announcement.
So if there are plenty of reasons for central bankers to reconsider the policy of ever-lower rates, what are the chances of politicians delivering major fiscal programmes? In the US, presidential candidates have plans to ease fiscal policy and there appears to be little resistance among the population: the federal deficit/budget ranks low on voters’ priorities according to pollsters. Of a total package of $1.5 trillion, Hillary Clinton plans to spend $250 billion on direct infrastructure investment and allocate another $25 billion to fund an infrastructure bank that may add another $225 billion to the direct spend. The programme would be funded through closure of tax loopholes elsewhere.
Donald Trump’s plans are centred on personal and corporate tax cuts and could potentially give a short-term boost to spending. However, funding these through increased borrowing would almost certainly lead to rising US bond yields as the market begins to attach an uncertainty premium to US assets.
Europe’s scope for fiscal support is constrained by relatively high levels of existing debt in many economies and a political aversion in “core” countries to increased debt. However, a succession of referendums coming up in the fourth quarter may deliver a clear message to the core that some fiscal support would make sense politically.
While Theresa May acknowledged the “bad side effects” of “super-low interest rates” at the Conservative Party’s 2016 annual conference, Chancellor Philip Hammond indicated that any fiscal response would be measured:
“We need to keep the lid on day-to-day spending… but I do think there is a case that we should look at very carefully for targeted, high-value investment in our economic infrastructure.”
Meanwhile, Japan’s latest ¥28 trillion (€250 billion) fiscal package announced by the government at the end of July underwhelmed the markets, while China seems to have abandoned large, untargeted stimulus programmes that deliver poor returns. So, apart from the US, the scope for global fiscal support would appear to be limited.
The US presidential election and the election calendar in the Eurozone will be worth following in the months ahead to see what the scope of fiscal support might turn out to be. Equities, particularly companies exposed to infrastructure investment, contracting and construction, would be a relatively better bet in that environment than bonds. However, that election calendar itself may raise volatility into year end. Against that backdrop, we continue to favour equities over bonds and remain committed to our fundamental philosophy that quality companies will deliver superior returns to investors.