Global financial markets are slowly but surely being weaned off the medicine of sizeable global liquidity provided by major central banks over the last decade. Extremely accommodating monetary policies are drawing to a close, providing more testing times for equity bulls. We are entering a new interest rate regime – a cycle that some analysts have not experienced.
The Federal Reserve (Fed) started the ball rolling in late 2015, raising rates gradually under the helm of Janet Yellen (replaced by Jerome Powell in early 2018) and slowly unwinding its sizeable balance sheet as of October 2017. The Bank of England surprised markets last November, hiking rates 25bp to 0.5% though this merely reversed the emergency easing implemented after the Brexit vote in mid-2016, fearing an imminent UK recession which proved wide of the mark. The European Central Bank (ECB) is gradually heading towards an exit strategy but a rate rise is unlikely before mid-2019.
The Bank of Japan (BoJ) is the odd man out, maintaining its commitment to a lax monetary stance until inflation has clearly reached its 2% target, unlikely before spring 2019. Deflationary pressures continue to linger in the aftermath of the bursting of the equity market bubble in the late 1980s, and its damaging impact on the Japanese banking sector.
The global financial crisis prompted a significant contraction in world growth in 2008/9. Wholesale lending markets froze up, triggering a severe credit crunch and significant corporate sector retrenchment, including layoffs and cutbacks in investment plans amid heightened fears of a prolonged and pronounced downturn.
A return to the dark days of the 1930s Great Depression was narrowly avoided thanks largely to significant rate cuts by major central banks, led by the Fed, and the introduction of Quantitative Easing (QE) - sizeable central bank purchases of sovereign bonds-aimed at boosting bank lending and encouraging increased risk taking via a positive wealth effect, belatedly joined by the ECB. In addition, a co-ordinated fiscal expansion across the globe helped to arrest a collapse in business and consumer confidence.
Initially, the US and UK economies were the main beneficiaries from aggressive central bank actions but this has filtered through to the Euro area more recently. Euro business and consumer sentiment reached multi-year highs in late 2017 as the ECB’s negative rate regime and sizeable liquidity injections into the banking sector bore fruit. A softer Euro was also supportive. Japan chalked up its eighth consecutive quarter of growth in Q4 last year, its best performance since the late 1980s, driven by strengthening domestic demand. Even Brazil and Russia are in the early stages of recovery, after suffering deep recessions, which bodes well for Emerging Markets.
Labour market conditions have clearly improved in the last few years. Unemployment rates have fallen to multi-year lows in the US and UK, stoking fears of rising wage pressures over the medium- term. Euro area consumers have been helped by higher real incomes, though youth unemployment remains a scourge in many countries. With commodities recovering as China avoided a “hard landing”, on a sizeable credit injection in 2015, global inflation has reached a trough in this cycle though it remains low by historic standards. Indeed, the IMF’s latest semi-annual report hailed the strongest pace of global growth this year since 2010.
The upshot is that G7 central banks have become increasingly confident that economies can withstand a less accommodating monetary policy, encouraging a gradual rise in official rates and less expansive balance sheets. A sustained period of ultra-low interest rates has allowed healing in the financial sector, including beleaguered Euro area banks, but has also raised concerns of a policy mistake in some circles.
Still, the Fed, BoE and ECB are likely to tread cautiously, fearing that a more aggressive stance could unhinge the current upturn given record high debt levels, particularly in the private sector. This is in stark contrast to the last four Fed tightening cycles
All in all, investors face more challenging conditions after global equities enjoyed stellar returns in 2017. The unexpected spike in the VIX volatility index in early February provides a wake-up call for complacent investors, positioned for a prolonged period of financial stability. The recent inexorable rise in equity markets and narrowing credit spreads, amid an apparent insatiable appetite for yield, is coming to an end as monetary policy is normalised. Investors will have to get increasingly used to reduced central bank liquidity, the recent lifeblood for risk assets.
Nick Stamenkovic is an experienced macro strategist who has written extensively on global economies and fixed income markets, providing bespoke research for a variety of clients across the UK.