“We are late in the economic cycle, yet interest rates remain low, meaning central banks will have to become even more imaginative to tackle the next downturn.”
Markets in early 2019 have been helped by the dovish turn in the Fed’s stance. Along with its promise to be “patient” on further rate hikes, the Fed has sent signals that it will soon end its balance-sheet reduction, thus helping ease concerns about tightening financial conditions.
With growth flagging and a certain lack of visibility on the trade and political fronts, central banks, like the Fed, have had little room to pursue policy ‘normalisation’. Slowing growth means the European Central Bank recently signalled a delay in its plans to tighten rates later this year, while the People’s Bank of China has been providing significant policy stimulus in response to a growth slowdown.
Although their deep-seated strategic rivalry will not go away soon, a certain rapprochement on trade matters between the US and China will increase visibility and could well give a further fillip to markets. So, too, could a stabilisation in earnings expectations (something that is possible, given the recent turnaround in the fortunes of energy companies). Confirmation that, despite slowing growth, recession is not imminent could likewise encourage risk taking. Indeed, we expect the present downturn in Europe and China to trough in the coming months. We might even see some fiscal stimulus in Europe, however limited.
Alongside our measured optimism, it may be legitimate to ask whether the Fed’s dovish turn marks a new chapter in central bank policymaking. We are late in the economic cycle, yet interest rates remain low, meaning central banks will have to become even more imaginative to tackle the next downturn. This, we believe, could mean the abandonment of inflation targeting along with stricter attention to financial market conditions and liquidity, especially given the high levels of leverage that have built up in parts of the economy, not to mention the large public debt burdens in much of the industrialised world.
With large or rising debt burdens a force for disinflation, the risk is that central banks’ 2% inflation target becomes ever more elusive. In spite of hefty doses of quantitative easing, they have still not met that target, with the Bank of Japan furthest behind. It may well be that central banks abandon their forlorn hopes on this front. They may concentrate instead on not upsetting markets, which could reduce liquidity for the most debt-laden corporates and countries via a tightening in financial conditions. In short, liquidity flows need to be maintained and the cost of credit has to be kept below nominal economic growth (about 4% in the US, 3% in Europe), something that will restrict central banks’ margin of manoeuvre in setting base rates.
All in all, we remain relatively upbeat about economic prospects, and we now expect that central banks, faced with the need to keep debt-laden markets and economies afloat, will keep the monetary spigots open in the months ahead, helping justify an expansion in earnings multiples even as earnings growth declines from last year’s high levels. We thus remain cautiously optimistic about equities.