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In the wake of the Global Financial Crisis (GFC), monetary policy-makers around the world assessed that an extended period of extraordinarily loose and unconventional monetary policy was warranted. The policy regimes that ensued dominated the investment landscape over the last decade but are now coming to an end.
Looking ahead, monetary policy drivers for financial markets are set to be very different as the long return journey to more “normal” policy settings is undertaken. Broad-based GDP growth has now returned and while there are some questions regarding the achievement of inflation targets, fears of ongoing deflation have all but vanished.
The Fed has already raised interest rates four times and expects to deliver one more hike this year, a further three in 2018 and something similar in 2019. Bond markets continue profoundly to doubt the Fed’s ability to deliver much more than two hikes in total over that period.
Against the improved economic backdrop, other developed market (DM) central banks are considering their exit options. The ECB is likely to taper asset purchases soon before raising policy rates slowly in 2018. The BoE has signalled that ultra-low interest rates may no longer be appropriate and the BoJ is unlikely to extend policy stimulus. Other central banks in both the DM and EM universes have already raised rates modestly and are likely to continue along the normalisation path over the next two or three years (Figure 1).
It is widely acknowledged that QE and very low interest rates provided significant boosts to many financial assets during the GFC. It is therefore understandable that there are concerns that the reversal of such stimulative policies will present a challenge to a range of asset prices (Figure 2).
However, the withdrawal of policy stimulus is a direct result of improving macroeconomic conditions and that will allow financial asset valuations to become determined far more by fundamental factors rather than unconventional monetary policy. It could be reasonably argued that several equity markets around the world have already made – or are making – this transition, being underpinned by much better earnings expectations, again linked to improved economic outcomes.
While this is a welcome evolution, it does not mean there will not be bumps along the way. Sovereign bond yields had fallen to historic lows during and after the GFC, reflecting the collapse in GDP growth and inflation (and threat of deflation) and the plunge in policy interest rates. QE added to the downward pressure on yields. As all of these now reverse, yields will have to react. The latest signs are that they are reluctant to do so, largely because of scepticism over whether the recovery is sustainable. But if growth does continue and inflation returns, central banks will become less accommodative.
If the world is truly getting better, markets will have to reassess where the risk free rate is and what the equilibrium real interest rate should be. The latter was probably negative in the GFC, but is now moving higher again. Rising term premia are an inevitable consequence, implying a downside risk to some equity markets that look expensive such as the US.
Although the threat of deflation appears to have passed, after an initial rebound inflation has either fallen back somewhat or remained stubbornly low in several countries. Wage inflation has also returned more slowly than expected. These trends have led to conjecture that inflation has not yet been restored meaningfully and that policy should therefore remain loose for much longer. This argument will only be settled in time, but our view is that inflation is slowly returning and that inflation rates will move back to target in most countries (Figure 3).
Moreover, recent inflation moves in some countries should not be over-interpreted: legitimate arguments can be made to explain much of recent weaknesses from one-off influences. Underlying trends may be slow-moving, but the direction of travel looks clear.
This is not to deny that the increasingly globalised nature of economies has borne down on inflation in recent years. That has clearly been a major influence, is likely to continue and should help prevent any nasty inflation outbreaks in the future. But it is unlikely to be sufficient to keep inflation sustainably below central bank targets in time.
Subdued inflation in the wake of the GFC should be no great surprise. Ultimately, if inflation is generated by the pressure of demand on underlying supply, then the largest recession in the post-war period was bound to result in minimal inflation pressures until spare capacity was reabsorbed into productive use to meet recovering demand. That has been happening for a while now, but the process is incomplete. It is most advanced in the US but probably has further to go in Europe.
Inflation does not look likely to take off anywhere at present, but markets’ scepticism about a sustained return to low, positive inflation (Figure 4) may be challenged over the next few years as the recovery continues.
There was no repeat of 2016’s Chinese growth worries at the start of 2017 and indeed throughout the year so far. In fact Chinese growth has surprised modestly on the upside in each of the last three quarters (Figure 5). The better news has been partly due to the improvement in global trade over the last year. (Figure 6) But part has been due to earlier active policy stimulus from the Chinese authorities. China looks set to beat its 6.5 per cent GDP growth target for 2017, even if growth slows a little in the second half.
This has provided an opportunity for the Chinese authorities to take advantage of the benign economic backdrop and address concerns in other areas. In particular they may attempt to tackle excess leverage in key parts of the system and hence prevent the build up of bubbles and other debt-fuelled excesses, including the property market. The risk is that they miscalculate the degree to which they can reduce leverage and cause a growth undershoot. Should that happen, policy would be swiftly reversed.
The October Party Congress is a key event and China will be keen to avoid any upsets before then. There is a perception that if President Xi can consolidate his power-base, that would signal further progress in reform and transition. Conversely, if old school party apparatchiks were to retain some control, there would a risk that China might embark on excessive reflation, culminating in bubbles and busts. From a financial perspective, stability in the Chinese economy should be assured as long as they can retain control over capital outflows. The opaque nature of Chinese data means that it will be difficult to discern any early warning signs of slowdown.
The raft of greater financial regulatory requirements introduced over the last decade was an understandable response to the GFC. And doubtless they will have made the financial world a much safer one for investors and set in place an environment in which the worst excesses from that crisis can not be repeated. Well-intended regulation can, however, sometimes result in excessive interference that prevents markets from functioning as they should. There is now a groundswell of opposition building against further regulation and even in some circles of reversing some parts of previous decrees.
Reduced regulation is most likely in the US, where Trump’s administration has a stated goal to ease the regulatory burden and free up institutions to allow them to operate more effectively in the future. Trump may find it easier to push through initiatives in this area as most do not require legislative change. It remains to be seen whether other countries follow this lead.
Across Europe there is less interest in a lighter regulatory touch, but there are some signs of a softening of their stance with regard to the final elements of Basel III which are expected to be phased in over the next two years. Lighter regulation could help offset some of the concerns regarding market liquidity. Figure 5 shows the Basel Committee’s estimates of the capital shortfall for the major banks if the Basel III requirements were fully phased in. Bank capital is now clearly assessed as adequate.
But it is unlikely to be a smooth transition and may take longer than expected. At the Jackson Hole conference in August, both Yellen and Draghi delivered warnings arguing against excessive loosening of regulations and roll-back of post-crisis rules, especially while monetary policy settings were still so loose, as they might be a threat to financial stability. Overall, peak regulation rather than lower regulation still seems the appropriate description.
Acceleration in nationalist agenda/trade tension
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