Highlights:
· The U.S. Federal Reserve is unlikely to aggressively tighten monetary policy until they see sustainable upticks in inflation.
· Both the European Central Bank and Bank of England began corporate debt-purchasing programs in the face of dwindling supplies of government bonds. The Bank of Japan also turned to an unconventional monetary policy of its own in an attempt to pump liquidity into its economy.
· The decline of the British pound has arguably served as the biggest cushion to the U.K. economy from the aftershocks of Brexit. Initial volatility attributable to the surprise result has greatly subsided as the ultimate fallout from Brexit will not be known for years.
· China’s central bank has been reluctant to cut interest rates or enact other strong monetary policy for fear of stoking further capital outflows and currency weakness. Nevertheless, economic growth remains firm and commodity shocks to surrounding emerging markets appear to be abating.
Commentary:
Central banks’ policy heavy-handedness continue to be the dominating force in global equity markets. Market shocks this year ranging from oil price falls to Brexit have been met by swift policy relief from central banks. The low-interest rate policies of many central banks continues to be the driver of the desperate search for yield for many investors.
We are now more than seven years into the U.S. economic recovery that began around June 2009. However, it is only recently that the recovery has started to result in meaningful wage increases which is welcome news for middle-class workers who have largely not benefited from the current economic expansion. Equity markets, meanwhile, continue to climb not necessarily because of expected higher earnings, but because of the persistently low value of the risk-free return (government bonds) driven by central banks’ aggressive monetary policies and stimulus measures. While a program of lowering rates and buying bonds has been successful in stopping the bleeding from the Great Recession and lowering unemployment rates, the Federal Reserve is going to need to supplement and eventually replace monetary policy with a growth agenda. Until the Fed sees measured upticks in inflation that support sustainable long-term growth they will likely be in no rush to aggressively tighten monetary policy. Periodic rate increases over the next couple of years are likely, although they will likely be quite tempered. Indeed, recent increases in the value of the U.S. dollar and long-term bond yields are giving the Fed second thoughts about raising rates again this year, which many perceived as a foregone conclusion earlier in the year.
Central banks in many developed economies are realizing that they are reaching the limits of their capacity for monetary stimulus even as they consider more extreme and unconventional stimulus methods. Having run out of government bonds to buy, both the European Central Bank and the Bank of England began programs of corporate-debt purchases during the quarter. The goal of this program is to lower borrowing costs even further for large companies already benefitting from ultralow interest rates created by massive government bond purchases over the last several years. Whether and how this capital gets allocated will likely determine if this corporate bond purchasing program is ultimately successful. In theory, a lower cost of capital should encourage companies to invest in their business and increase capital expenditures. But the ECB and BOE need look no further than the U.S. where since the Federal Reserve took interest rates to near zero, U.S. companies have boosted stock buybacks and dividends at a significantly greater clip than investments. Getting businesses to ramp up spending would likely go a long way towards spurring global economic growth and appeasing investors who remain skeptical that monetary policy addresses the global economy’s central issue of soft demand for goods and services.
The Bank of Japan has channeled huge amounts of cash in to its economy the last several years by buying massive quantities of government bonds and, most recently, pumping money into infrastructure projects, with little success in changing the deflation mindset that has permeated the country for the last two decades. Now facing a looming scarcity of government bonds, the BOJ also turned to unconventional monetary policy of its own in an attempt to pump liquidity in to its economy. The latest approach involves introducing a target for 10-year interest rates in an attempt to keep the yield on 10-year Japanese government bonds at zero and encourage lending by its banks. The BOJ is attempting to not just meet its 2% inflation target, but overshoot it. This is truly a test of the conventional wisdom that long-term rates are set by market forces and can’t be fully controlled by central banks. The hope is that a combination of low long-term interest rates and increased government spending will finally bring Japan out of its decades-long deflationary spin.
Fresh on the heels of its vote to leave the European Union (“Brexit”), the Bank of England cut its benchmark interest rate to the lowest in its 322-year history and revived a bond-buying program last used during the financial crisis. These measures were taken to cushion the U.K. economy from the aftershocks of Brexit, but to date, it has been the decline of the British pound that has acted as the largest shock absorber. For all of the pandemonium in the immediate aftermath of Brexit, almost four months later the stock, bond and real estate markets have held up, employment is steady, consumers are still spending and inflation is at its highest rate in nearly two years. Despite these initial positive signs, our opinion is that Brexit’s long-term effects for both the UK and the European Union will not be known for years.
China’s central bank on the other hand has been reluctant to cut interest rates or enact other strong stimulus measures, as such meashures have been perceived to fan speculation in property and bond markets and might stoke further capital outflows and pressure on its currency to weaken. Rather, they have taken to making more subtle monetary moves as of late, including injecting short-term liquidity into banks and using a range of other lending facilities to inject longer-term cash into the system. These moves, coupled with government infrastructure spending, appear to be working as the most recent economic data appears to indicate that the economy is stabilizing.
While a consensus may be emerging that a move away from monetary policy and towards fiscal policy having a bigger role in stimulating the global economy is necessary, the heavy involvement of central banks around the world is unlikely to dissipate anytime soon. Considering the ongoing fight against terrorism, a raucous U.S. presidential election and unsettling events occurring seemingly daily on every continent, it would appear to be mayhem in many parts the world. However, we would posit that while many of these events can be troubling, they are also actually expected and normal. Although the impact they can have on short term market volatility can be signficiant, in terms of their impact on investment policy, they should be deemed short-term noise. The premise for the investment policy of your portfolio relies on long term statistics and is designed to allow you to be indifferent with regard to these events.
Urban Financial Advisory Corporation - October 2016