A decade-long enigma about to be resolved

Ever since developed-world central banks threw themselves headlong into ultra-loose monetary policies at the beginning of 2009, the big question has been how exactly they would unwind them. If unconventional monetary policy ultimately failed – that is, if inflation and GDP growth plummeted – financial markets would almost certainly have been rocked by a devastating crisis of confidence. That risk is now behind us. The prevailing view among market participants these past few years has been that economic growth and inflation rates were out of the danger zone, but still low enough to warrant unlimited continuation of highly accommodative monetary policies. That view was supportive of all asset prices. 2018 is finally bringing investors the hoped-for happy ending from an economic standpoint. Growth and inflation have picked up, allowing central banks to make the case that the interventionist monetary policies of the last several years have worked, and can therefore be scrapped. But that also means we have entered an inevitable phase of market instability, where the tough question will be how to assess the implications of this exit process for all asset classes.

When monetary policy entered uncharted territory in 2009, we were treated to a whole slew of spectacularly wrong forecasts. The prospect of an inordinate expansion of the money supply prompted many economists to predict a major surge in inflation that would drive bond yields up sharply. At the same time, they argued that equity markets could hardly perk up as long as economic growth remained so feeble. Needless to say, things worked out quite differently, with both stock and bond markets experiencing unprecedented rallies. Moreover, in a supremely ironic twist, as long as central banks were unsuccessful in kick-starting GDP growth and inflation, they could be counted on to provide investors with further support in the form of massive cash injections. In the process, they encouraged those investors to take on additional risk as a means to capture somewhat higher returns at a time in which interest rates were being deliberately driven lower and lower. Getting market forecasts right is no less critical today – as unconventional monetary policies unwind – than it was back in 2009, as both situations were equally unprecedented.

In 2018, earnings per share are expected to gain 18.4% in the United States and 7,5% in the Eurozone

The tax cuts passed by the US Congress late last year have raised hopes of an economic surge in the country. On average, analysts now reckon that in 2018 output will grow by close to 3% and inflation will top 2%. Forecasts for the Eurozone, meanwhile, are for roughly 2.5% GDP growth with inflation close to 1.5%. With this favourable economic climate set to continue, earnings growth forecasts for 2018 have been lifted several times since the start of the year; earnings per share are now expected to go up 18.4% in the US and 7.5% in the Eurozone. That brighter outlook for American companies may explain why US stocks in general and tech stocks in particular have gained further ground despite upward pressure on bond yields, and why they are still outperforming their European counterparts. However, this consensus view is going to be confronted with two distinct challenges, one in the short term and the other a bit further down the line.

After years of compression through central bank intervention, US, Japanese and German government bond yields have entered a dicey process of gradual adjustment to real market prices. That adjustment will be anything but plain sailing. Market participants will constantly have to rethink the economic forces at work, the signs of rising inflation they may detect and the impact of central bank reaction functions. A serious look at the recent US tax reform strongly suggests that it will force the US government to borrow more – just when the Fed is starting to reverse its own contribution to liquidity by shrinking its balance sheet.

It follows that one of the key challenges in the coming months will be quantifying the net impact that such a dramatic shift in the supply-demand equation will have on Treasury yields. That shift is likely to create even greater instability in equity markets as investors’ views get tainted by renewed fears of higher US inflation – fuelled by an unfavourable base effect and rising wages, the Trump administration’s renewed embrace of protectionism and lingering political uncertainty in Italy. In addition, the sheer volume of assets managed using passive investment styles and investment algorithms is liable to magnify erratic market swings.

The imbalances that have built up of over the past ten years raise major adjustment issues

The imbalances that have built up over the past ten years raise major adjustment issues. Debt levels, both for governments and businesses – which have by and large taken advantage of low interest rates to increase their leverage – stand higher today than just after the 2008 financial crisis. The number for the entire US economy is now equal to 250% of GDP, while the Japanese government alone has reached the 200% mark. In the Eurozone, public sector debt has risen from 72.8% of GDP in 2009 to 83.2% today. Investors expect the current economic upswing to bring higher inflation in its wake. For the time being, the upside of that expectation is that it lowers the real cost of debt and strengthens the case for investing in equities to offset the erosion of the value of cash.

From this standpoint, the main risk is that the Fed and other central banks might respond to this improving environment by tightening monetary policy too sharply. Investors are wagering at this point that central banks will be sensible enough to keep their key rates low or negative – even at the risk of lagging behind inflation trends – in order to avoid toppling the fixed-income house of cards. Now, that wager may seem rational, but it’s worth recalling that those same central banks have already scheduled the termination – or even reversal – of their asset-purchase programmes. More importantly, no one knows what the long-term equilibrium price for government paper will be, especially if the threat of inflation lasts, when demand from private-sector investors has to take up the slack left by central banks. That risk provides ample justification for maintaining an extremely active approach to managing bond duration.

The US business cycle is already close to its peak. Despite the tax cuts, the country’s leading economic indicators point to a possible cyclical slowdown between now and the end of the year. Meanwhile, China has just released disappointing PMI readings for February. In the Eurozone as well, such economic indicators as consumer confidence and the PMI have fallen off slightly – a first since 2016. And in the United Kingdom, the trend reversal is already under way. So investors today may well be wrong to dismiss the idea of an upcoming cyclical slowdown, particularly if the current market turbulence were to further undermine consumer and business confidence. Such a turn of events would limit the risk of a deeper bond-market correction, but it would also heighten the disparities between sectors in the stock market space. It would usher in an environment where scarcer growth becomes the new paradigm, and companies in cyclical industries or with heavy debt loads might once again find themselves in dire straits. In contrast, the outlook would be brighter for high-growth firms with healthy balance sheets and good earnings visibility – a breed with a large presence in US equity markets.

Going forward, no investment strategy can deliver results unless it rests on alternative approaches to the ones that have worked in the past few years. Managing the nascent market instability and crafting portfolios correctly for the new era awaiting us will be crucial to success.

Source: Bloomberg, 03/03/2018