Opposing views on the timing and effects of quantitative tightening suggest investors should be cautious of high valuations
• There are conflicting views on whether the Fed is tightening too slowly or too fast
• The breakdown of the Phillips curve – which shows an inverse relationship between the unemployment level and the inflation rate – complicates the normalisation of monetary policy
• The actions of the Fed have the greatest impact on global equity markets
William McChesney Martin, the chairman of the US Federal Reserve from 1951 to 1970, famously declared that the role of the central bank was akin to that of the chaperone who ordered the punch bowl removed just when the party was really warming up. If that is the case, then the imposition of quantitative easing (QE) by central banks must be akin to them passing round the whisky bottles at a funeral wake. For better or worse, the actions of central banks are an important factor in prospects for global equity markets.
All central banks are focused on delivering enough growth to generate low but stable inflation of about 2% a year, says Karen Ward, chief market strategist at JP Morgan Asset Management. “The tricky thing for any central bank is to know when to step off the accelerator and start to touch the brake.”
Central banks attempting to actively stimulate markets has been a notable feature made famous by the ‘Greenspan put’ when then Fed chairman Alan Greenspan lowered the Fed Funds rate several times leading to higher asset valuations, reduced credit spreads and increased risk-taking.
This has aroused great criticism but, says Ward, the Fed would always say its goal is to meet an inflation target and an equity market collapse would feed into consumer confidence, affecting consumer spending and hence inflation. “Even Greenspan would say he was targeting inflation via consumer confidence,” she says.
After the global financial crisis, already-low interest rates meant the Greenspan put strategy was no longer viable. Instead, central banks began using unconventional monetary policies in the form of QE to achieve the same objectives. But global equity markets are now facing the aftermath of QE as central banks tackle the objective of returning to more normal monetary policy.
The Fed has indicated three rate hikes next year on its road to normalisation, with other central banks still some way behind in the post-crash recovery strategy.
Central bank policy, however, is complicated by the fact that an important feature of the past decade has been the breakdown of the mainstay of economic policy, the Phillips Curve, relating inflation to unemployment. In its simplest form, it indicates that when unemployment is low, wage inflation and hence consumer price inflation is high, because workers can bid up wages. “It is the epicentre of analysis – the Phillips Curve is all we have got,” says Ward.
But, says Shamik Dhar, chief economist at BNY Mellon Investment Management, there has been a crisis of faith over the past decade. No one knows what the relationship is between inflation and employment anymore.
Despite this shift, central banks are still focused on the implications. “They believe there is a kink and at some point they expect a take-off in wage inflation, which is why they are raising rates,” says Seema Shah, global investment strategist at Principal Global Investors. She says the Fed’s actions are appropriate for an economy growing strongly with the labour market extremely tight and unemployment way below the neutral level. “I would understand if they wanted to continue at this pace provided there is no market adjustment,” she says.
Dhar outlines two opposing views on the trajectory of the US equity markets. First, there is a group of market participants who are worried that the US economy is close to capacity and wage inflation is picking up. From this perspective, the Fed is slightly behind the curve if anything. That means the emergence of higher inflation in the next year or so is possible. In such a situation, the Fed would have to raise interest rates, bond yields will go up and stock markets will be hit. It is the story of inflation surprise.
The alternative view draws on almost the opposite set of conclusions. From this perspective, the Fed is tightening too far, too fast, irrespective of what is happening to inflation, because the fundamentals of the global economy look poor with trade wars, higher oil prices and a gloomy outlook for corporate earnings. Against this background, the prospect of three hikes by the Fed next year is overdoing things. The global economy outside the US is not doing well. While the US may be experiencing a sugar rush driven by tax cuts and repatriation of foreign earnings, emerging markets are vulnerable for three reasons, says Dhar.
First, many emerging market companies have borrowed heavily in dollars to invest in local opportunities producing local currency revenues. As US interest rates and the dollar goes up, these investments become less profitable and the cost of their funding goes up dramatically.
Second, oil prices are high and a lot of emerging economies are oil importers, so their current-account balances get worse and markets do not like that financial vulnerability – which explains problems with Turkey and Argentina.
The third reason is trade tensions, most significantly in Asia where countries are part of the supply chain that essentially supports the Chinese export model. But Dhar argues that the Fed would not stick rigidly to an interest rate hike regime if the world economy is going to slow: “I would be surprised if the stock markets were weighed down for too long unless the Fed makes some sort of policy error.”
Of all the central banks, the actions of the Fed are likely to have the greatest impact on global equity markets, The Fed, however, is facing strong political pressures from the Trump administration which is causing concerns over its independence. The questions facing the Fed is how frequently should they act in reaction to adverse market moves. Shah says the central bank should be raising rates every quarter with the US economy as strong as it is currently. Yet, in October, global markets saw significant corrections but, as Shah points out, there are significant corrections of 5% or more in equity markets on average every 72 or 73 days. Has the Fed given up on stimulating markets?
Perhaps not, says Arnab Das, global market strategist at Invesco. “We believe the Fed put still exists but is ‘far out of the money’ at present.” It would require a much more severe financial-conditions shock to occur in the US equity market or credit markets to impose enough drag on the real economy to cause the Fed to even stay its hand, much less reverse course, given the strength of the economy, Das argues.
He doubts that a financial-markets shock by itself would be enough, unless severe enough to impose a substantial drag on the US economy. For investors, the conclusion is that even if the Fed put still exists, it is not a good reason to be bullish at lofty asset valuations.