As an introduction, for too long central banks have dominated financial markets. After the crisis in 2008, they crashed interest rates to ultra-low levels and printed money like it was going out of fashion to restore confidence and jumpstart economic growth. Financial markets responded by rising almost indiscriminately. Now, after a decade of extraordinary monetary stimulus, global growth seems to be on a sure footing. With it, a pivot away from central bank led monetary policy appears to be happening. We need to understand how this might play out and what it entails for our clients.
A decade after the financial crisis, the reality on the ground is finally better. Many developed economies are enjoying above average growth. The US is growing at a pace of 3% against an estimated 1.8%. In the eurozone, despite a marked deceleration this year, growth is expected to come close to 2% against an estimated 1.25%. Across all developed economies, unemployment levels are at historic lows and there is gathering evidence of labour shortages. In the US, firms are dropping requirements for drug testing and disclosure of criminal records. Non-monetary staff benefits are also being improved to retain workers. US unemployment, at 3.7%, has not been this low since 1969. In Japan, labour markets are displaying acute shortages – there are more than two new jobs opening for every new job seeker.
Rock bottom unemployment rates and labour market shortages are forcing central bankers to raise interest rates to prevent economies overheating. The US Federal Reserve is the furthest forward; it started increasing interest rates in 2016 and has raised rates seven times so far to the present level of 2.25%. Despite the uncertainty caused by Breggsit, the Bank of England has raised rates twice and the European Central Bank has given strong guidance that Quantitative Easing will conclude at the end of 2018 and interest rates will start rising after September next year. Even in Japan, where deflationary forces are deeply entrenched, the pace of QE has slowed markedly from annual money printing of 80 trillion yen to just under 30 trillion yen.
Meanwhile the Trump administration is undertaking an extraordinary fiscal expansion by cutting taxes for the rich. This is adding nearly 1% to growth just at the peak of the economic cycle, a massive experiment that is unorthodox, unnecessary and unprecedented. In the UK, Prime Minister May declared at the Conservative Party Conference that austerity is over; a UK government under Labour or the Conservative Party is set to boost public spending. We despair of all politicians with their short term, publicity-seeking deceitfulness.
In the euro area, there is a battle taking place between the populist agenda of the Italian government and the European Council’s more conservative stance. In reality, an easing of the fiscal stance in Germany will go a long way to reduce the internal imbalances in the euro area. Even so, there will likely remain a constant drumbeat of populist governments seeking to redress these imbalances through looser fiscal constraints. In other words, they want to tax, borrow and spend more.
The pivot away from monetary policy (money printing) to fiscal policy (raising taxes) is a dramatic shift that is occurring now. As interest rates continue to rise, the cost of capital will increase, leading to slower growth for businesses – the world turns on credit. While the pivot is greatest in the US, the impacts will reverberate
across the world, particularly to emerging markets such as China, India, South Africa and large parts of South America as global funding costs are often linked to US interest rates and paid in US dollars. For emerging markets which have borrowed in dollars, there is a double tightening of financial conditions underway.
The US under Trump is planning $1.5 trillion worth of tax cuts, mainly for the wealthy, nine years into an economic recovery. Coupled with robust private investment this will likely lift US GDP growth above 3% for 2018. Unsurprisingly, such a policy does not come without risks; most obviously rising interest rates and bonds yields, a soaring dollar and a potentially spectacular increase in debt (the Congressional Budget Office suggests US debt/GDP could approach 100% by the end of the next decade – a level normally seen only in war time). This year alone the American budget deficit is predicted to be 4.2% of GDP, or almost twice the level of the worst case Italian budget deficit for 2019 that is getting Rome into such hot water with Mrs Merkel.
The arbiter of the success of this experiment will likely be the bond markets - and this month we have seen the first warning shot. The bond markets are where companies all round the world obtain credit to invest in new factories, machinery and technology so they can grow faster, and it is also where governments go to finance their state benefits, retirement pensions and spending on vanity projects such as HS2, the two new nuclear reactors at Hinkley Point, or the completely pointless Trident nuclear programme.
The President has shown he can persuade Congress to back his tax agenda and is wholly unafraid to give the Federal Reserve advice on interest rates, but the bond market is a new sort of foe. For a start, a large chunk of US government debt is held by foreign investors ($6.3 trillion or almost twice as much as foreigners held in 2008) with China ($1.2 trillion) and Japan ($1.1 trillion) the largest. In the case of the former there is now added uncertainty in that the highly aggressive use of sanctions by the Trump administration may encourage the Chinese to attempt to reduce their dollar investments. This might impact on the demand for US bonds from other foreign governments. More generally, bond investors are highly sensitive to inflation rates – in this respect the President’s decision to impose sanctions on Iran (regarded by many in the oil industry as among the toughest ever adopted) have already helped trigger a rise in oil prices of more than 25% this year. Nervous foreign investors and rising oil prices have not often been good for America.
For investors all the above has led to higher market volatility, as we clearly saw last month. Notwithstanding a brief surge in February this year, share price volatility had remained remarkably subdued – trading at around 13, a level well below the 25-year average of 19. There is evidence to suggest that share prices will remain volatile as the US continues to raise interest rates, so don’t expect the burst of volatility we saw last February or again last month to be the last. To this end many of our carefully chosen fund managers are holding higher precautionary cash balances in their funds until things settle down and they can then benefit from lower prices.
In conclusion then, this is not a time to change our investment strategy, which has always been to firstly preserve and then, where possible, grow the real value of your capital.