Last week was certainly eventful, as global equity markets underwent ‘corrections’ in excess of 10%, as accompanied by record levels of withdrawals in response to a realisation that the safety-net of ultra-loose monetary policy, in the form of ultra-low interest rates and asset-buying by central banks, is to be withdrawn. This hasn’t come as a shock, and most certainly shouldn’t be mistaken for economic fragility.
Equity prices, very simply put, are by their very nature a tussle between inflation (which should result in earnings growth) and the discount rates at which those higher earnings are present-valued. With central bank intervention over recent years, the equity markets have soared to record highs as they have been able to relax their assumptions on discount rates. Market movements this week are a reaction to the realisation that this is no longer the case. Furthermore, increased volatility should be expected as there is a growing emphasis on the suitability of a discount rate. Whilst in recent years the margin for error has been small in a rising environment, there are more permutations to consider, particularly when starting from an artificially low base as we are.
The issue of pricing is further complicated for investors by the enormous fiscal expansion the US is to undertake in the coming years. This market invention is delivered in two tranches, the first being the tax reforms which lower the tax-burden of firms and have helped drive equity markets to their historic highs. The second is increased government spending, which will take effect following the passing of the budget this week. The reason for the controversy is less that it needed democratic support to pass or that in doing so it saw the Republican Party accused of abandoning their fiscal discipline and more to do with its timing in the business cycle. With the US economy at full employment and witnessing the highest year-on-year wage increases since 2009, as well as robust economic growth, it seems unnecessary and even irresponsible. These budgetary plans at this time are only going to add fuel to fires of inflation fears. That’s not even to mention the ballooning fiscal deficit, which is set to exceed 5% of GDP for the foreseeable future. These two factors alone were evident on Wednesday when demand for US treasuries was labelled ‘weak’ as investors demand a higher yield.
These challenges warrant a steady hand at the helm of the central bank that is charged with installing confidence in the economy. Not a great week for Jerome Powell, the new untested Federal Chairman, to take charge then. He will have to be delicate in handling the four rate increase expected this year, the first of which will be next month.
Even the Bank of England is taking a more hawkish tone, despite Brexit having a dampening effect on domestic economic growth. At the MPC meeting on Thursday, economic growth forecasts for the next three years were slightly increased to 1.8% per year as British exporters avail themselves of higher demand, driven by synchronised global economic growth and a depreciated pound. However, the MPC was forced to raise its inflation and wage expectations as it became clearer that supply capacity will fail to keep pace with this surging demand, as a result of firms being reluctant to invest, much to Mark Carney’s frustration.
As a result, a 0.25% rate hike in May has a 70% probability, with some analysts predicting another one to two increases to follow later this year. Should this be the case, base rate could reach 1-1.25% by the beginning of next year. A steep increase when you consider that the five-year swap rate is currently trading at 1.35%. However, whilst the increase in short-term rates is getting all the attention, I would keep an eye on longer-term rates projections which are currently extremely flat, with the 10-year swap rate at 1.60% and the 20-year rate at 1.75%. Should this part of the yield curve steepen, we could see a more profound impact on asset values, particularly those focused on income rather capital appreciation.
Whilst Mario Draghi of the ECB appears on the face of it to be committed to loose monetary policy, the markets aren’t buying it, with the five-year swap rate reaching 0.42% having been % at the beginning of the year. It is the markets’ increasing belief that should the Italian elections produce a ‘favourable’ result then Draghi will immediately turn his attention to reducing the ECB’s balance sheet, with a potential rate increase to follow soon after.
For the week ahead, look to UK CPI figures on Tuesday which are expected to show steady figures in January. Friday’s retail figures should reflect a small rebound from December. For the Eurozone, look to industrial production figures on Wednesday.