State Of The World

The pain endured by financial markets in the final quarter of 2018, was wiped away, as we moved through the first three months of this year. Combining interest rate increases with a reduction in the size of its balance sheet, saw financial conditions tighten to such a degree in the United States that the Federal Reserve (Fed) had to undertake a major policy volte-face, versus prior expectations for further interest increases in 2019, and additional quantitative tightening.

 

 

State Of The World

“When the facts change, I change my mind. What do you do, Sir?” – John Maynard Keynes (Economist).

The pain endured by financial markets in the final quarter of 2018, was wiped away, as we moved through the first three months of this year. Combining interest rate increases with a reduction in the size of its balance sheet, saw financial conditions tighten to such a degree in the United States that the Federal Reserve (Fed) had to undertake a major policy volte-face, versus prior expectations for further interest increases in 2019, and additional quantitative tightening.

Described by one commentator as a “screeching U-turn”, going from promising a steady decrease in the size of its balance sheet and flagging continued interest rate increases, to saying neither is assured within the space of six weeks was quite the change! Many investors had been clamouring for just such a U-turn, given the sell-off in share prices last December and the surge in Government bond prices that were lifted by declining yields as recession risks rose. As a result of the Fed’s change of direction, asset prices were off to the races, as the S&P 500 logged a 13% gain through to 31 March, the best quarterly showing since the summer of 2009 (in US Dollar terms). Credit has likewise marched higher, with the Bloomberg Barclays High Yield Index jumping 7.3%, the steepest quarterly rise since 2003. The Fed’s dovish swivel was completed in late March as US interest rate futures, a measure of expectations, now expect rate cuts instead of further increases, and quantitative tightening is set to end in September.

All of this happened whilst economic expansion in the US is now three months shy of a record length. In fact, the Statement of Economic Projections, issued by the Federal Reserve in March, saw estimates for Gross Domestic Product (GDP), inflation or unemployment barely move over the entire forecast horizon. Despite that, the US Government bond yield curve, which has historically been a good indicator of the prospects for a recession happening when longer-term interest rates drop below near-term rates, inverted briefly. According to UBS Bank, on average a US recession occurs 19 months post the aforementioned yield curve inversion. What the Chairman of the Fed did acknowledge in March, was the Central Bank’s failure to achieve its inflation target of 2%. Stubborn disinflationary trends appear to be causing concern, because it would become incredibly difficult to fight the next recession, whenever that may be, when consumers and investors have no confidence in the Federal Reserve’s ability to do so and, therefore, it needs to remove disinflation risks out of the picture pre-emptively.

It should be noted though, that Central Bankers should be especially careful about changing their minds abruptly. In an era of fiat currencies, Central Bank credibility is all that backs money. A U-turn as obvious as the Federal Reserve Chairman’s could, therefore, damage the credibility of the Dollar itself.

Monetary policy is said to operate with a considerable time lag. It could well be that the market carnage seen in the final months of 2018 and the recovery witnessed in the first three months of this year, is the natural consequence of the American Central Bank’s policy actions to date. The policy U-turn should be welcomed given the Pavlovian magic impact the Fed has on markets. It cannot be known conclusively, however, what single variable would be responsible were the US economy to go into recession when the Fed was not just raising interest rates, but shrinking its balance sheet at the same time.

If the Federal Reserve has been successful in arresting market fears regarding the US economy, then what of other major countries? One commonality has been the uniform reaction of Central Banks across the globe in early 2019, which has been to pivot to additional stimulus or to guide the market to not expect any rate rises in the near future. The economic slowdown that began last year has carried through to early 2019, and is described by Gavekal Research as “an odd development”. Logically, with cheap oil, low interest rates, limited credit worries and a stable US Dollar, the global economy should be booming. However, it is not. From here, you can come to one of two possible conclusions. Firstly, the global economy is going through some kind of soft patch; maybe a mid-cycle slowdown, or maybe just a speedbump linked to political uncertainty around the US-China Trade War and Brexit. But whatever the reason, it won’t last and soon growth will be roaring again. Or secondly, this time it is different, perhaps due to structural problems for a number of key industries, the demographic shift occurring in most Western and East Asian countries, or a secondary depression – presuming the capital spending boom in China has come to an end would mean a lot of investment needs to be written off.

As we begin the second quarter, it appears growth has begun to reaccelerate. J.P. Morgan report that global services’ PMIs are running above trend (for two months). US employment data has bounced back, and a trade deal between the US and China appears within reach. China has also engaged in fresh policy stimulus and the European Central Bank plans more stimulus in June. With this backdrop, as we head into the earnings season, it is sensible to adopt a tone of cautious optimism even without us having once mentioned Brexit! Just watch the Pound.