Aug 31, 2020
• Federal Reserve guides to lower for much longer.
• No major central bank minded to raising rates over the medium term.
• Credit markets continue to be attractive in the absence of a positive cash yield.
• Emerging markets have a huge opportunity to exploit.
• Low rates and accommodating monetary policy not necessarily helpful for value stocks.
Central banks finally admitted that things will never go back to normal. Low rates are not transitory, they have become structural.
Central bankers caved-in at their Jackson Hole and were in our view openly admitting that today’s levels of interest rates (or lower) will be with us for many years to come. We expect credit spreads to trade close to lows, and growth assets to maintain or extend their seeming high valuations.
This year’s annual meeting of global central bankers at Jackson Hole, Wyoming, like so much this year, has been unprecedented. The symposium took place in virtual form against the background of a severe shock to global activity from the pandemic. Central bankers continue to strive to find a policy kit that will engineer a recovery to close the yawning gap between actual and potential output that could persist for years to come.
Fed chair Jay Powell’s announcement of a new strategy on inflation targeting (or framework) marks the most significant upheaval in the shape of the Federal Reserve’s policy apparatus since the Volcker era in the early 1980s. The new policy carries substantial potential implications for how financial markets operate. It will undoubtedly influence the debate over a more significant and longer-term role for expansive federal government fiscal policy. Neither can we ignore the impact of the Fed’s shift of policy on other central banks such as the ECB. Many will feel the pressure to follow the Fed’s lead.
It is still very early days in devising a new role for central banks post-crisis – we have no idea whether the strategy will prove useful nor have a real sense of the distortions that the new policy may generate. The Fed also starts on the back foot. Despite engineering a significant reduction in the unemployment rate before the pandemic, ever since the financial crisis it has failed to deliver on its target of 2% per annum inflation. Meanwhile, the Fed appears to have cut the level of where it assumes a neutral interest rate (neither restrictive nor stimulative) sits, and market expectations for long-term inflation are at only 1.75% despite the hugely aggressive actions taken by the Fed in recent months.
The Fed now considers that the current environment represents a risk to the downside to both its longer-term maximum employment and price stability goals, especially as interest rates are near the zero level lower bound. Going forward, the Fed is saying that it will look to target an average inflation rate of 2% p.a. over an unspecified period which of course will take account of intervals where inflation undershot the target. Not just that, the Fed is also taking a more dovish stance concerning how far it will let the unemployment rate fall and how quickly it will respond. It is signalling that it will want to see clear evidence thattighter resource utilisation will generate sufficient inflation to carry it to its new average-for- a period goal. Economists expect this new framework to be in place for at least the next five years.
It is not just a Federal Reserve that is reassessing its central bank policy toolkit. The European central bank is due to announce potential changes to its policy framework by the middle of 2021. The Governor of the Bank of England also suggested last week that a range of strategies, including negative interest rates, could be employed in the future.
While we see that the policies could have a meaningful impact on asset prices, we still struggle to see how they will have a significant effect on the global economy. Creating inflation requires excess demand oversupply. However, central bank policies have obliquely responsible for keeping businesses in business and not allowing healthy destruction of failing (large) companies. Good cases in point, in the year-to-date, include the airline and auto industry. Such broad support for industry also means the capital remains wrapped up in low performing assets and is not recycled into new opportunities. Critics of the Bank of Japan and its efforts to create inflation, often focus on its broad support for companies that should years ago have been allowed to go out of business. The Bank of Japan, despite all its efforts, has failed to create consistent inflation in over two decades.
In our view, enabling reflation requires both a reshaping of monetary and industrial policy- Central banks and governments. All that central bankers have achieved since the world financial crisis is to evolve their transitory policies into what the markets perceive as structural support for asset prices. Investors have no fear; the central banker will always ride to the rescue.
What does it mean for asset markets?
There could be significant implications for the financial markets relative to what we have seen even in the last decade. A US economy running hotter for longer is now seemingly a policy objective. As with fiscal policy, the Fed is likely to remain a very aggressive interventionist market player for some time to come. It will use all the tools available to it since the financial crisis and even more. We are also likely to see a more significant partnership with the Federal government. The Fed looks committed to supporting government deficits for years to come. We expect interest rate guidance to be more assertive on occasions and support for key sectors of borrower more explicit.
The Fed’s direction of travel on monetary policy only adds to implicit support for credit markets. Investors are in effect, being encouraged to take risk, because, in the absence of the emergence of a significant amount of inflation, the Fed will stand in the market as a backstop for credit markets.
So far bond markets have responded in a way that the Fed might appreciate- the yield curve has steepened as long-term interest rates have moved higher, the dollar has weakened, and equities rallied. Yet reflation in the eyes of many investors faces massive structural headwinds exacerbated by the pandemic. Also, global geopolitics and local US politics remain highly uncertain.
Lower-for-longer US$ interest rates will provide significant support for emerging-market assets. Emerging market currencies live in fear of high nominal and real dollar interest rates – fear no more. Jay Powell would not have said what he said at Jackson Hole unless the Federal Reserve policymakers felt that they would have to maintain low-interest rates for an extended number of years, not months. Indeed, emerging market local currencies suddenly look that much less risky and undoubtedly more attractive to international investors.
Low-interest rates and support for credit markets keep cyclical companies in business, but they don’t necessarily help them generate economic profit. Hence, we still have a healthy level of scepticism that value stocks can perform. Growth stocks with their long-term profits growth discounted by low-interest rates will remain the preferred route for investors to buy equity exposure. There will be merit in income stocks but only to the extent that they can protect their dividend payments. Central bankers support bond coupon payments by making them smaller! Central bankers don’t protect equity dividend payments in the same way.