Investors question central bank action

Posted on September 12, 2016

Men looks up at an electronic screen displaying stock figures at the Bombay Stock Exchange (BSE) in Mumbai, India, on Tuesday, June 7, 2016. Indian central bank Governor Raghuram Rajan kept the benchmark repurchase rate at a five-year low of 6.5 percent, the Reserve Bank of India said in a statement. Photographer: Prashanth Vishwanathan /Bloomberg©Bloomberg

The market’s somewhat eerie summer lull, abruptly shattered by tumbling equity and bond indices in the last few days, was never truly sustainable.

Now, investors are starting to question whether seemingly interminable central bank stimulus has finally met a limit.

    The recent fall in the ISM manufacturing survey into contractionary territory, followed by the sharp drop in the more important non-manufacturing survey, should be enough to keep the US Federal Reserve on hold until after the US presidential election.

    That’s coupled with slightly weaker than expect payroll growth in August, adding to concerns. Clearly the US economic cycle is maturing, with initial jobless claims at very low levels relative to the past 40 years. When jobless claims have been this low in the past it’s rarely been much more than two years until the next US recession. But timing is everything.

    Medium term recession risk in the US is rising, but recent gains in consumer confidence, home sales and the absence of an inflection point in the labour market suggests the US economy will probably avoid recession within the next few months.

    As a result, expect US monetary policy to become slightly less accommodative, albeit at a glacial pace. Meanwhile, super lax, easy-money policies from central banks outside the US are still anchoring markets.

    The European Central Bank is extremely likely to extend quantitative easing beyond March 2017. There has been no immediate economic slowdown in Europe as a result of the Brexit vote, giving the ECB comfort that no emergency response was required at the latest meeting.

    That may have disappointed investors in the very short-term, but we should not assume the ECB believes their job is done. Just consider that closely watched Eurozone core inflation is still firmly stuck below target, with little prospect of a dramatic rise over the next six months.

    Investors are also fretting that the ECB faces operational challenges — running out of bonds to buy or room to cut rates further. But this anxiety seriously underestimates the commitment and inventiveness of the ECB.

    While there may be policy implementation challenges ahead, the likelihood of the ECB throwing in the towel and admitting defeat in achieving its inflation target is close to zero. Investors would be unwise to doubt Mario Draghi’s determination.

    In Japan, investors are calling into question the capacity for continued stimulus, with some fearing that the Bank of Japan’s upcoming comprehensive assessment will be used as an opportunity to back away from the aggressive, ambitious and yet entirely necessary goal of sustainably lifting Japan out of its deflationary malaise.

    In contrast to these fears, the coming BOJ meeting is likely to re-emphasise their commitment to achieving their inflation target. The policy rate is likely to be cut further into negative territory and QE purchases are likely to continue at a rapid pace.

    The hunt for yield has no respect for geography and thus continued policy stimulus from the ECB and BOJ should keep medium and long term government bond yields anchored at low levels. The Fed’s increasing focus on a lower terminal rate, along with the rising medium term recession probability, should allow the Fed to raise the short end of the yield curve without a tantrum in bond markets. US 10-year yields are in little danger of breaching 2 per cent this year.

    With bond yields still hovering close to record lows and a recession on the back burner, developed equity markets are unlikely to experience a sharp enough fall to warrant significant portfolio de-risking

    With bond yields still hovering close to record lows and a recession on the back burner, developed equity markets are unlikely to experience a sharp enough fall to warrant significant portfolio de-risking.

    That said, an unspectacular growth outlook combined with a maturing economic cycle limits the potential for strong capital gains in the rest of the year. Low volatility over the summer had probably led to an increase in portfolio leverage among those managing portfolios on a value at risk basis, contributing to the sudden moves over the last couple of days, triggered by misplaced concerns about the sustainability of accommodative ECB and BOJ policy. These worries should ease.

    Yet there is a panoply of political events on the horizon from the upcoming Italian referendum, potentially yet more elections in Spain to the US election (with the now added complication of concerns over Clinton’s health), not to mention the German and French elections next year.

    So even without a recession, we’ve seen the last of the summer calm. Equities are likely to tread water for the remainder of 2016 but in bumpier seas. This environment of still low bond yields and range bound equities argues for seeking income from both equity and fixed income markets for the rest of 2016.

    Michael Bell, Global Markets Strategist at J.P. Morgan Asset Management.

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