The headline act of ‘financial repression’ is finally due. By the end of this year not only will the US Federal Reserve (Fed) be reducing the size of the balance sheet, but we also expect the European Central Bank (ECB) to announce a tapering of asset purchases in its own quantitative easing (QE) programme.
These moves have been well-broadcasted and should not be news to investors although, throughout my investment experience I have been frequently surprised by how latent the reaction can be. Financial assets have clearly been supported by QE over the years (see graph) and a change of direction is a notable event. The comfort is that both Mario Draghi at the ECB and Janet Yellen at the Fed are understandably nervous about a policy mistake and any changes will be incredibly incremental.
The Fed currently reinvests maturing securities to keep the total assets on the balance sheet at the same level (US$4.5 trillion). As of October, we expect it will begin a reduction in reinvestments at a rate of US$10 billion per month (US$6 billion of US Treasuries and US$4 billion of mortgage-backed securities). All other things being equal, this reduction is expected to increase in size quarterly to a modest US$50 billion per month by the end of 2018.
The ECB is not reducing the balance sheet, but is expected to taper its monthly purchases from €60 billion down to €40-45 billion from next January. Net purchases have actually already been declining since their peak in 2016, but over the next year, Central bank net asset purchases are expected to fall from approximately US$100 billion (or the equivalent) per month currently to around zero.
In other words, the global liquidity engine that has driven down bond yields and provided liquidity for stock markets will stop by the end of 2018, and then potentially reverse as we move into 2019.
The decisions that lead to global tapering by Central banks are based on a varying combination of greater confidence in the growth and inflation outlook, political factors, financial stability and technical limitations.
Next year, global GDP growth is expected in the region of 3-3.5% and inflation at 2.4-3%, delivering a relatively healthy total nominal global growth picture of 5.5-6.5% that will help to offset the negatives of liquidity reduction. The recovery in Europe in particular has exceeded expectations, with a welcome improvement in credit growth, consumer confidence, earnings and employment.
In the US and the UK, policymakers are very wary of overheating. Unemployment in these two economies is down to levels normally associated with stronger wage growth, and lagged implementation considerations have prompted a rate tightening bias in the US and tension at the Bank of England.
Even in Japan, where we saw 4% GDP growth in the second quarter and unemployment at just over 2%, the Bank of Japan may need to consider a higher target rate for the 10-year bond if wage inflation finally perks up.
The conundrum is that wage inflation has largely been absent, and outside of currency-driven dynamics, inflation in general has also been benign. QE enabled excess capacity to persist in the global economy by depressing the cost of capital. The return on money will converge to zero if the price of money is near zero, and in this environment, any real pricing power or inflation will evaporate. Tightening liquidity raises the cost of capital through higher interest rates, driving down excess capacity and leading to higher inflation.
In our view, wage inflation in the US is missing because of disruptive technology and the US labour force participation rate (see graph below). The fall in participation rate from 67% in 2006 to 63% in 2015 suggests that approximately six million Americans could come back into the labour force before we get back to a tight market and see wage inflation rising.
Many of these potential entrants may have permanently left the work force and the opioid epidemic has had a material impact on the younger demographic, making it difficult for the Fed to know where the inflection point will be. The Fed also needs to consider the policy lag effect to combat the inflation risk that they currently cannot predict, making it doubly hard for market participants to predict the path of monetary policy.
Debt levels globally remain extreme and are the key reason for policymakers to tread carefully with higher interest rates. After all, government treasury departments also need to issue a lot of debt to finance their economies!
Therefore, the most probable outcome is that monetary tightening will be very gradual and the impact on equities is likely to be limited. Interest rates determine the discount rate used to value equities and a small change in rates will result in a small change in valuations.
At the same time, a combination of strong global growth and modest inflation are a boon to earnings. Equities are not cheap in absolute terms, but very little is these days. Bonds are definitely no bargain and real assets such as property, art, vintage cars and wine have all appreciated markedly (the 1958-1973 Ferrari index is up 100% since 2008).
Sentiment may deteriorate in the short term as investors assess the impact of the changes to the purchase programmes, and the historical evidence is inconclusive regarding the likely outcome. But on a relative basis, equities are still good value in our view and an improving earnings growth picture is encouraging. Even on an absolute basis we still consider equities to be fair value rather than expensive, and we expect returns to remain materially higher than government bonds and cash over the longer term.
The contribution of disruptive technology is an important element of growth, and its impact on productivity is probably significantly understated in the official numbers. It presents massive challenges to the incumbents, many of whom are struggling to adapt. US retail malls used to be a stable place to invest but these days you can buy them for a song, raze them to the ground and develop residential real estate.
Technology advancement is generally a positive dynamic and the global tech super hubs of Shenzhen and Cupertino are growing fast. It can refresh and reset an economy and some of the best economic growth periods in history relate to innovation.
Quite a few of the stocks in the new economy currently appear overpriced, but differentiating the winners from the losers is fraught with difficulty. Some will grow into their valuations successfully and others are likely to fail. However, the point is that the influence of technological change is good for growth. It is the catalyst for recycling capital into productive assets, for keeping inflation under control and is generally good for equities.
The known unknowns and reasons to be wary are mainly political. We saw a great example of how politics drive markets earlier this year when European stocks performed very well into the French election, and the reverse dynamic is equally possible.
The Trump administration and Brexit leave a political void in the US and Europe that mavericks like Kim Jong-Un opportunistically fill. Brexit poses significant economic challenges and serious political risks for the UK and, in turn, it poses a probing question over any strong domestic equity bias in our portfolios. Many companies in the MSCI UK Index are indeed international in nature, with significant overseas earnings, but some may move as a result of Brexit and the post- Brexit world may lessen the appeal for new companies to list in the UK.
China and possibly India are the likely beneficiaries of these political uncertainties, with China in particular having a clearly defined long-term path for growth and international policy. Their sphere of influence across the developing and developed world will increase at a faster pace if the US and Europe are focused on internal issues. An increasing dominance of either China or India has the potential to move the centre away from our traditional comfort zone, making it even more important to factor changes in Asia into our outlook and asset allocation.
For more information on our latest investment views please contact us on 020 7189 2400 or email@example.com