By Philip Smeaton, Chief Investment Officer at Sanlam UK
A roller-coaster news agenda has failed to destabilise markets so far this year. Even the threat of a nuclear war has failed to dent market confidence. It goes to show that when conditions are good, the market can choose to ignore whatever ‘catalyst’ presents itself. In more cautious times, that catalyst might have a bigger impact.
Investors have started to lose interest in the Brexit and Trump soap operas, and are paying closer attention to the normalisation of monetary policy and how that will play out over the coming months. While the scale of quantitative easing in 2008/9 was a departure from the economic status quo, removing it after almost a decade is equally as significant. Now that economic growth is picking up in the world’s three most important economic regions – the US, China and Europe – central bankers have signalled that they will gradually wean the economy off the drug of easy monetary policy, and the US is leading the charge.
Wiping trillions of dollars from the US balance sheet
When the financial crisis struck in 2008, the US Federal Reserve (Fed) aggressively cut interest rates and injected capital into important markets that investors were too scared to touch. It’s generally accepted that this decisiveness prevented a depression.
Over the years that followed, the Fed bought around $4.5 trillion dollars of government and other bonds, which equates to 25% of US GDP. As these bonds have matured, the money has been reinvested into similar bonds, keeping the size of their investment roughly constant, and having a neutral impact on the market – until now.
Starting this month, the Fed will start to reduce the amount it reinvests, gradually reducing the size of its holdings by $10 billion per month, which will steadily increase until it reaches $50 billion per month. This won’t surprise markets in the immediate term, but no-one really knows how it is going to play out in the coming years. Our best guess is that by buying these bonds in the first place, the Fed forced bond yields lower, making it more attractive for companies to borrow money and grow the economy in the process. So, reversing this should have the opposite effect, pushing bond yields up.
Will Japan, the UK and Europe follow suit?
Europe and Japan are some way behind the US on the path to normal monetary conditions. Indeed, they are still buying bonds. Japan is likely to continue doing so for some time as their recovery is still very weak, but we expect the European Central Bank (ECB) to announce plans to ease off its quantitative easing program. Who knows, maybe this time next year the ECB will be talking about their first interest rate hike, if you can consider going from minus 0.3% to zero a hike.
The Bank of England is pre-occupied with rising inflation, hinting it will increase interest rates before the end of this year. We’re concerned that an interest rate rise is premature. Inflation is simply a function of the weak pound, and should return to the bank’s target level of 2% without their help. Again, time will tell.
The outlook for inflation
It’s the consensus view that global inflation is likely to stay low for the foreseeable future. We think this makes sense, but holding the consensus view means we must be extra careful not to be caught in a stampede when everyone is changing their mind at the same time. After all, as the graph below reminds us, this isn’t the first time that a benign inflationary environment has changed quickly.
Nevertheless, there are good reasons to think that inflation will remain near the 2% target:
- Central banks will be quick to act if inflation rises, in fear of it destabilising the economy. Indeed, the Bank of England is already demonstrating discomfort, despite the fact inflation is far from out of control.
- There is limited evidence to suggest that low unemployment rates will lead to inflation (through increased wages).
- Commodity prices suggest continued moderate levels of inflation.
- The impact of technology and an ageing population are still factors in keeping inflation low. Technology makes things cheaper, and an ageing population means less demand.