Boiling the

Pascal Blackburne & Luc Synaeghel 2017-09-07

The month of August was certainly noisy, with Hurricane Harvey and escalating North Korean military provocations dominating the headlines. Such commotion should, however, not detract investors from what we consider to be the crucial longer-term development: the normalisation of monetary policy – assuming of course that a dire scenario will be avoided in North Korea.

As regards Harvey, far from us the intention of belittling the damages inflicted to Houston residents. That said, from a multi-year viewpoint, such events do amount to noise only – shifting GDP growth between quarters and causing an uptick in market volatility. Even for oil, Harvey is but a temporary factor. Analysts have been prompt to conclude that US inventories will rise because the closure of Texan refineries outweighs the loss in production from the Gulf of Mexico and the Eagle Ford basin. They forget that two major US ports have also had to shut down, restricting oil imports. Ultimately, and regardless of the near-term weekly pattern, we hold to our view that excess oil inventories are progressively being resorbed. Regrettably, until that process has run its course, the oil price will remain in the hands of speculators.

Getting back to monetary policy, we find it intriguing that, measured in common euro terms, the three major equity market indices (S&P 500, Euro Stoxx 50 and Nikkei 225) have posted closely correlated – and downward-oriented – performances for the past few months. This despite a strong earnings season across nearly all business sectors. To the extent that they undergo less “manipulation” (direct interventions) by central banks than bond markets, we would argue that faltering equity markets can be seen as advanced indicators of monetary policy reversal.

Central bankers will obviously strive to engineer a gradual decline

By definition, a return to more normal monetary conditions also means more normal bond and equity markets, in which the risk taken by investors is afforded a premium. At current valuation levels this is simply not the case, making a correction inevitable over time. In the interest of global financial stability, central bankers will obviously strive to engineer a gradual decline – preferable from their standpoint to a brutal crash. In other words they will try to boil the frog.

Concerning bond markets, the question is: what level can be considered normal for interest rates, such that lenders be rewarded for the risk taken, for the term of their loans and for inflation? History suggests that 10-year government bond yields should eventually re-align with nominal GDP growth rates, around 4-5% in the US and 3-3.5% in the Eurozone.

Hence the “slow strangle” that we posited a couple of months ago. Gradually correcting equity markets and rising rates do not make for an attractive combination from an investor perspective. While we feel comfortable with our (already defensive) fixed income positioning, we have made adjustments on the equity side, shifting our broad European index exposure into mid-caps and targeted domestic segments. Not only should all be less vulnerable to a rising euro, but the latter also stand to benefit from higher rates (banks) or appear particularly cheap (telecom, utilities).

Jackson Hole a non-event - or not ?

Amid the hectic August news flow, the Jackson Hole gathering of everyone who matters in the world of central banking went almost unnoticed. On past occasions, Federal Reserve (Fed) and European Central Bank (ECB) chairs had used that venue to make important announcements about the future direction of monetary policy. Not so this year.

But it may actually be a matter of no news being the real news. Put differently, the very fact that Janet Yellen and Mario Draghi said nothing of consequence at Jackson Hole could be a sign that monetary policy is indeed returning to normal. Supportive forward guidance was the ultimate step in monetary accommodation, taken by central banks when zero short-term interest rates, the first step, and bond purchases (quantitative easing), the second step, were no longer sufficient to convince financial markets.

Thus far, the Fed has already hiked rates thrice. A couple of months ago, it also made clear its intention to reduce its balance sheet. This process could begin as soon as next month – particular if recent early signs of rising money velocity are confirmed. Faster circulating money would indeed make it more urgent for the Fed to remove the liquidity punchbowl, or risk losing grip on inflation.

The ECB is less far along the route to normalization, having only – marginally – reduced its monthly asset purchases. But it is not impossible to envisage that quantitative easing be terminated in 2018 – with a return to positive short term interest rates also conceivable.

The situation is somewhat different for the Bank of Japan (BoJ) whose continued massive bond purchases stem not just from monetary policy considerations but also have to do with managing the massive public debt problem (>200% of GDP). The BoJ has by now bought close to half of the outstanding government bonds. Ultimately, monetization of an important part of these bonds in one way or another seems the only possible route for Japan – hoping that it can be done in a manner understood by financial markets, so as to avoid a financially destabilizing and yen-destructive outcome.

Dwindling equity returns

3indexeseuroSource: Bloomberg

Viewed globally, it seems likely that the monetary engine will have reversed gear by the latter half of 2018. In turn, does this not explain the lackluster behavior of major equity indices over the past three months already?

Measured in euro terms, the S&P 500, Euro Stoxx 50 and Nikkei 225 indices have indeed all dropped a few percentage points since the end of May. Not a disastrous hit to performance as yet, but a slow downward grind which, if it persists, stands to durably pressure portfolio returns.

And a gradual correction is precisely what central banks will strive to steer. The risk of course, given the massive leverage currently pervading the financial system, is that liquidity evaporates as asset prices fall – spinning the downward move out of control (we remember 2008 all too well).

Should that occur, threatening the very stability of the financial system, central banks would have little choice but to turn the money tap back on – with potentially severe inflationary consequences.

Either way, investors need to fasten their seatbelts. If we are right in believing that Western world monetary policy is now at a crossroads, then the asset price party of the past few years is nearing its end.