Posts tagged ‘central banks’
We are now more than half way through 2016. As the year dawned this blog identified monetary policy and the oil price as two of the key things to watch. This week it was the turn of the Bank of England to set tongues wagging on the monetary front; in the meantime the oil price, which has done some central banks such a favour in recent years, has stabilized in the $45-50 range following its strongest quarterly rise for seven years.
The Bank had been expected to cut policy yesterday (from 0.5% to 0.25%). A Brexit loosening to buoy confidence had been the thinking behind this consensus. The MPC, however, held steady. Admittedly the consensus was not especially strong: of the 54 estimates collated by Bloomberg 25 had been for a 25bp cut, 6 for larger cuts and the remaining 23 (who won the bet) for no change. Nor was the defeat especially hard. The MPC announced that “most members of the Committee expect monetary policy to be loosened in August”, further noting that the “precise size and nature of any stimulatory measures will be determined during the August forecast and Inflation Report round.”
If, in the words of one senior figure on Threadneedle Street, the British economy needs a post-referendum “sledgehammer” (not an obvious choice of metaphor for a stimulus but one catches his drift), then why delay? If the Bank is to bolster confidence why didn’t it just get on with it? What sort of doctor decides that his patient, suffering some obvious ailment, could really do with a shot in the arm – but then decide to wait another month before administering it?
On the other hand, as that senior figure – MPC member Andy Haldane, the Bank’s chief economist – further put it, while there is some evidence of weakness in hiring and investment: “There is no sense of slash and burn. But there is a strong sense of trim and singe.”
In any event the point is that we do not yet know what the impact of the Brexit vote has been. There is anecdotal evidence from the property market, for instance. But it won’t be until at least early August that we have much actual data to look at.
There is an irregular exception which we ought to deal with quickly. GfK, who produce the UK consumer confidence series, undertook a one-off bonus survey in the aftermath of the referendum. (Their regular end-June number was based on surveys conducted during the first two weeks of the month.) Published last Friday this showed a fall in the index from -1 to -9, the biggest monthly decline since December 1994. On the other hand, the index has averaged precisely -9 over the last 30 years, peaked at only +7 in mid-2015 and went as low as -39 at the nadir of the Great Recession.
One thing we do know for a fact, however, is that the pound is 7% weaker, trade weighted, than it was when the last Inflation Report was published in May. It is down 11.5% in 2016 to date and has fallen 13% since its peak just under one year ago. Currency weakness is itself a form of monetary loosening which translates into imported inflation, higher exports and (not allowing for Brexit fears) greater inward investment. Is a cut of 25bp on the base rate really required as well? Particularly as the urgency of such a move is clearly not great enough to obviate the delay associated with data releases as well as the elegance of wanting to time MPC action to coincide with the publication of the Bank’s own detailed economic and monetary analysis?
And so back to oil. This is now back at exactly the level it settled at for a few months from last August. Very soon, then, the deflationary effect it has over the previous year will reduce to about zero. In February the Bank put the contribution of cheap oil to annual CPI at -0.4% through direct effects alone. That is quite a lot of disinflation to be giving up. The next RPI and CPI prints come out on Monday, with figures for July only arriving until after the next MPC meeting. So they may not be sufficient to challenge what will doubtless be a 100% consensus, backed by the MPC’s own words, for a 25bp cut next time. But the direction of travel is clear.
There is also the labour market to consider: 186,000 jobs were created during the first quarter of this year, and the ILO unemployment rate at 5% is only 0.3% off its 2004 low. Brexit risks may argue for a rate cut (though again, on that basis: why wait?) But the pound, the oil price and the labour market argue at least for staying put in August too.
The complication for investors here is that markets were already mildly disappointed with the Bank’s failure to cut yesterday. Put it off again, or postpone it indefinitely, and their disappointment may lose that mildness.
There is another possibility to consider: that Brexit fears might recede in coming months. What then for prices? And for monetary policy? And for bond markets, with the UK base rate not priced to rise above its current level until the end of 2020?
As so often our central bank finds itself in a bit of a spot. Nervousness pushes its hand one way; known fundamentals to date, at least, another. If the data which comes out between now and the next MPC meeting is unhelpful to the consensus the Bank can either act inappropriately or spook the market. If the data is poor, and so helps the post-referendum blues argument, then that is bad news for the economy.
Whatever the longer-term consequences of Brexit for the UK the shorter term prognosis for assets of certain types does not look rosy.
Central bank activity has been a linchpin feature of market activity in recent years. Rather than following rate trajectories and getting on with life, markets have been paying such attention to every last detail of bankers’ announcements and emergency programmes around the world that there have been some curious butterfly effects. In 2013 for instance the Fed announced that one day, quantitative easing would come to a halt. Now this programme had exhibited next to no economic effect on the US itself. But it weakened the currency of Brazil to such an extent that rates went up to defend against import price inflation, thereby contributing to that country’s recession and associated woes.
So what have central banks been up to lately, and what might come of it?
In the US the Fed has attracted criticism for its confusing guidance ever since it bottled tightening policy last autumn. The most recent statement from Chair Yellen said she was “cautiously optimistic” on prospects for the US economy, and she has said on several occasions that she would rather point people towards indicators which the Fed follows than give specific commitments to policy decisions in advance, which is understandable. But it has created uncertainty: some observers find signs in the data that the Fed is falling behind the curve, while others see no case for any more tightening at all this year. Markets are pricing in no move over the summer – which conflicts with Fed briefings as recent as 12 days ago – but expect the target rate to have risen to 0.75% by the end of 2016. Bloomberg summarized the situation well in a piece headlined: “Yellen Data Dependence Leaves Investors Dazed And Confused“.
For investors, this means continued uncertainty over the imminent path of US interest rates and that is not a comfortable situation for markets to find themselves in. Today’s sell off in equity on both sides of the Atlantic is, in part, a reflection of this. As to what will actually happen it is plainly anyone’s guess though if oil remains at the $50 level the deflationary contribution from energy will fade in August, core inflation remains above 2% and last week there was a positive data surprise in the form of a 4.7% unemployment rate (down from 5% and a new post-Great Recession low). Fundamentals aside, however, the Yellen era has been characterized thus far by uncertainty and that remains the key watch point from the Fed at present.
Over at the ECB talk on monetary measures has quietened down, though a noteworthy kilometrestone was reached this week when the bank began its latest phase of QE through buying corporate debt. Mr Draghi has instead been opining on supply side reform and keeping a studied silence on some issues which might possibly be of broader interest, such as the ability of Greece to finance itself next month.
That particular elephant in the room, and perhaps – who knows? – a Brexit vote here in a couple of weeks will give investors rather more to chew on than the ECB’s plans for monetary policy over the next few months. Having said that, eurozone unemployment has stayed stuck above 10% despite what passes there for a robust rate of growth. (Mr Draghi certainly does have a point about structural reform.) There is no realistic prospect of monetary tightening for a long time: markets suggest 2020. The ECB watch point for markets will be rhetoric and planning over emergency measures. However effective they may or may not be in practice their announcement always carries the power to disappoint and while a second-order issue relative to European politics at the moment this remains a source of risk.
Over at the Bank of Japan the story is similar. The yen has strengthened by 11% this year which is a disaster for Japan’s economy. Abenomics, too, have been faltering for some time. Deflation is back. The central bank is torn over the issue of negative interest rates adopted earlier this year and whose effects, if there are to be any, have yet to be felt. At a public meeting this week Deputy Governor Nakaso signalled the BoJ would do more if needed – but this was possibly nothing more than an effort to talk the currency down.
The BoJ’s next meeting is next week. It has not attracted half so much of the market’s attention as the Fed or the ECB but as in Europe the watch point is the reaction to policy announcements. If the BoJ adopts more emergency measures unexpectedly that could give Tokyo a nice boost, especially if it led to a weaker yen. The interest here though is more domestic than global for now.
Over at Threadneedle Street there has been a period of calm – at least on the monetary front. (Mr Carney’s regular warnings about the dire consequences of a Brexit have been a feature of life at the Bank of England since the early spring.) Rates wise expectations are as low as they were during the panic in February and the futures market is not pricing for an increase in the base rate until the second half of 2018.
In terms of things to watch the Old Lady is at the more interesting end of the spectrum. Carney has decried negative rates as ushering in a “zero sum game” via currency wars but that was before the hideous spectre of Brexit loomed. The possibility of negative rates has been mooted by one of his MPC confreres and if the Bank is serious about its rhetoric a Brexit vote could see a major surprise in that direction. That would potentially be great news for gilts but probably not much else.
On the other hand the May Inflation Report, as usual, forecast that under present conditions CPI would bosh back up to 2% in time to meet the Bank’s commitment to that target on a two year horizon. We know about the fading of energy-driven deflation. We know that the UK economy is at or close to full employment. The industrial production number for May was the strongest in nearly four years and core CPI inflation, which bottomed at 0.8% over a year ago, has yet to fall below 1.2% in 2016. So we could find ourselves with something of an earlier hike than is currently priced in, and that again might surprise markets depending on the circumstances.
Despite the dominance of politics there is thus much to follow from the central bankers, and most of it would seem to present more of a threat to risk markets than an opportunity.
Yesterday, just before lunch, some information was released by the Bank of England about the timing of the UK’s first rate hike. As a result, the pound posted its biggest one day fall against the dollar since August’s ghoulish gurgitations, the FTSE 100 reversed its morning losses and gilt yields fell across the curve. We know that markets are hanging on to every scripted syllable out of central banks these days – and the Old Lady had clearly delivered some big, big news.
Rather unfortunately it was not clear from the coverage exactly what this was. The headlines were all over the place. “Bank of England signals rates can remain at lows until 2017”, declared the FT, echoed by the equally authoritative voices of The Economist – “The Bank of England may not raise interest rates until 2017” – and the Daily Express (“Interest rates may not rise until 2017, hints Bank of England”). On the other hand the Daily Telegraph asserted that “Global growth risks likely to keep rates at record low well into 2016, BoE suggests”, a more hawkish position putting it in the same corner as The Guardian (“Bank of England to leave interest rates at 0.5% until well into next year”).
So what had happened? Had the Bank signalled, hinted or suggested? And was the substance of whichever denotation that it would hike next year, or the year after? A year is a long time in these uncertain markets, and it would be useful to know.
The headlines were inspired of course by the release of the unmissable quarterly that is the Bank of England’s Inflation Report. But what could explain such varied interpretations of exactly the same material?
Look below the headlines and there were suggestions, or perhaps signals of the answer. The Economist piece, characteristically, brimmed with patriotic vigour, noting that Britain’s economy was now so pathetically weak that it couldn’t even produce the laughably stunted amount of inflation necessary to warrant a single miserable rate rise. The FT referred to the forecast path of inflation. The Express covered the bases on both domestic growth and inflation, while noting the impact of weaker growth abroad in passing. Both the more hawkish papers touched on this ground too, but interestingly also gave space to the impact of low commodity prices and a seemingly contrarian view that the domestic UK economy remained resilient.
This blog does its own homework and usually reads the salient parts of the Bank’s Inflation Report, together with the accompanying and much shorter but (if anything) more instructive Conditioning assumptions, MPC key judgements, and indicative projections data. And it is obvious from the latter that future assumptions about energy prices are much lower now than they were back in the summer – understandably so: as the small print tells us, they are based on futures prices and these have fallen. The Bank’s new prices for gas and oil in 2016 are respectively lower by nine and ten percent. As the s.p. further helpfully explains, these numbers “are used as conditioning assumptions for the MPC’s projections for CPI inflation, GDP growth and the unemployment rate.”
Given that these energy price effects will prove more or less transitory – even assuming they do not reverse over the Bank’s two-year forecast horizon – it is perhaps foolish to read too much into them. It is certainly a mistake to confuse them with weakness in the domestic economy. As Governor Carney himself noted in an afternoon interview with Bloomberg Television:
“My personal view is it is important that we look at [core CPI] particularly because of this imported disinflation, it shows up through core inflation,” he said. “What we want to avoid is to have cost pressures build up too much domestically to the extent that once these foreign factors ultimately pass through the economy, we’re overshooting that inflation target because of domestic strength.”
And the headline of this piece? “Mark Carney: Prudent to Expect U.K. Rate Rise in 2016”.
In these uncertain times, let us refresh ourselves by beginning with what was again proved this week to be an indisputable fact: Mario Draghi is the most significant and successful central banker in the world.
The announcement three years ago that the ECB was assuming the power to intervene in bond markets, when he was not even 12 months into the job, put the sovereign debt crisis to bed, restored market confidence across the world and helped turn the creaking hull of the eurozone supertanker away from recession. Two years later his €400bn bank liquidity programme and adoption of a negative policy rate had analysts calling him a rock star. Another €700bn splurge and surprise rate cut followed. And at the beginning of this year Mr Draghi announced a €1.1trn programme of quantitative easing.
So yesterday’s announcement that the ECB was ready to modify the “size, composition and duration” of its QE exercise was part of a pattern. Draghi and team are being seen to do whatever it takes to re-normalise the eurozone economy. Indeed, as he put it at a speech he gave in London on 26 July 2012:
The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.
Everybody believes you now, Mr Draghi.
Market reaction yesterday and overnight was, in a word, electric. The euro plunged by 1% against the dollar in the space of half an hour to close the day 2% weaker overall. (That is a more significant one day fall than the planned devaluation of the Chinese yuan that caused such consternation back in August.) The Euro Stoxx 50, which had been trading flat throughout the morning, rocketed up in the afternoon to post a +2.5% close. European bond yields hit new record lows: the 2-year bund was pricing at -0.35% in the opening hours of this morning while the 2-year Italian buono hit negative yield territory for the first time.
There is a good, detailed overview of the global impact of Mr Draghi’s latest star performance from Reuters here: Global Stocks Hit Two-Month High On Dovish Dragi Message. But it is the quotes from market observers which we will focus on before leaving this subject:
“Investors and traders are buying the idea of expected action out of the Bank of Japan and the ECB,” said Ben Le Brun, market analyst at trading platform provider optionsXpress.
The Chinese central bank’s injection of 105.5 billion yuan into 11 banks via its medium-term lending facility this week, combined with possible additional stimulus from the ECB, “may give the Fed more reason to raise rates by year end,” said Chris Brankin, chief executive officer of online trading platform TR Ameritrade Asia in Singapore.
“Draghi has come out and kitchen-sinked the whole thing, everything is now on the table,” said Gavin Friend, a strategist at National Australia Bank in London. “You combine what the ECB is now saying with (the fact) that the Fed is not going to be going aggressively and that the Bank of Japan is going to want to get involved, then you say ‘Blimey!'”
Mr Draghi has played his role exceptionally well, but the dominance of central bank rhetoric and activity over market behaviour is unhealthy. When the People’s Bank of China devalued over the summer for example it was treated as a disaster – a desperate act to prop up a seriously weak economy. The falling stock market in China had helped unsettle the world and the markets’ interpretation of events took place against a background of gloom. This week, however – thanks to the ECB – we inhabit an era of sunshine and optimism. So when the PBOC announced further monetary loosening today it was seen not as desperate but as a sign of “the government’s determination” which has now lit “a fire under global stocks” as “US equity futures jump”, to quote some of this afternoon’s commentary. Markets hated Chinese policy over the summer and loosening by the PBOC was taken badly; today it’s just what was needed to cement the rally in place.
If there is a cloud to go with this week’s silver lining, therefore, it is the now familiar truth that reliance on central banks has become a major source of volatility. “Money Markets Primed for Draghi as Bets Jump on Deposit-Rate Cut”, says Bloomberg’s headline today. And what if there is no cut on 3 December? Or if there is, but this is seen as bowing to market pressure – the kind of pressure which appears now to govern decision-making at the Fed? One day markets are given a boost by “Super Mario”, the next, they start looking for more – and pricing it in.
Volatility is the textbook definition of financial market risk. Mario Draghi is, to say the least, an impressive figure. He has given investors much to be very grateful for. But he and his confreres around the world, counter-intuitive though it might seem, have actually helped to make investing today a riskier proposition. To put it another way, we have become used to looking to central banks to underpin market stability; and by relying on them to the extent that we now do, ensured the exact opposite.
The big news this week, of course, was the Fed. Rarely has inaction been so exciting! The statement put out by its Board of Governors is quite pithy as these things go and worth a read in full, and the salient policy points are all sandwiched within a single paragraph as follows:
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account … labor market conditions … inflation pressures and … expectations, and readings on financial and international developments. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.
US unemployment for August was 5.1%, down half a point from the beginning of the year and nearer the bottom than the top of the Fed’s own range for the “longer-run normal rate of unemployment” of 4.7-5.8%. There is nothing here to justify emergency monetary conditions whatsoever. Despite the statement, therefore, the US labour market was in practice irrelevant to the decision taken by its central bank.
On inflation, the Fed notes elsewhere the “transitory effects of declines in energy and import prices”, and is absolutely right to do so. Fortunately it also has access, just like the rest of us, to “core” measures of both consumer and producer price inflation which specifically exclude food and energy. Headline CPI has crashed down from 2.1% in the spring of last year to 0.2% today, but the core measure has risen this year from 1.6% to 1.8%, not meaningfully distant from the stated target of 2%. Again, this is not consistent with an emergency monetary stance.
Having abandoned at least one and a half of the two elements of its mandate, then, the Fed has effectively announced it is acting with reference primarily or solely to an unofficial third: “financial and international developments”.
In one sense this is a masterstroke. Attributing loose policy to sources other than the domestic economy eliminates the risk of a bearish response to a downbeat assessment of the situation at home. (The Fed has come a cropper here before.) When a central bank produces an economic assessment that is news. When it points to events offshore that everyone has already seen, it says nothing new.
From another angle, however, yesterday’s decision does not look quite so masterly. Invoking the stock market as a reason for cheap money used to be known as the Greenspan Put, a source of moral hazard under the eponymous Fed chairman which attracted some of the blame for the financial crisis. And at least efforts were made to justify Mr Greenspan’s option writing in terms of a “wealth effect” on US household spending. Extending the put to the stock market in China seems startlingly multilateral even for these enlightened times.
Furthermore, all the Fed has done is postpone a move which would have taken nobody by surprise if they had done it this week. It is still perhaps a little early to gauge the market reaction but stocks are down in both the US and Europe today. The dollar has weakened just a touch against the euro, is pretty much unchanged against sterling and the yen and the Chinese yuan has not budged, so there is as yet no consoling impact for American exporters and multinationals. All that is certain is that the postponement has prolonged a key source of uncertainty.
The impact of a 25bp rate hike would have had a negligible impact on everything apart from sentiment. And it is far from clear that its market impact would have been any worse than that of the Fed’s eventual, barely defensible decision to dither.
So much for the new mandate to shore up financial and international developments.
Kudos, in conclusion, to Jeff Lacker, President of the Federal Reserve Bank of Richmond, the only one of the Fed’s twelve decision-makers to vote for a hike yesterday. His colleagues have in reality opted for nothing more cogent than mañana.
This morning’s leading headline on Bloomberg News read as follows: “Stocks Advance in Europe, Asia Amid China Holiday … ”
Without the peril of the Chinese stock market to contend with, European bourses were up by 1-2% early in the day and are higher at the time of writing. This certainly fits the narrative of those who see the collapse of the supposed equity bubble in China as the source of all the summer’s ills.
(Before moving on, a brief comment on that “supposed”. The Shanghai Composite Index rose by 58% from the start of this year to its peak on 12 June, having risen by 53% in 2014. It hit a p/e of 23.5x in the process – then began to fall. By the bottom on 26 August the drop had reached 43%. If that isn’t a bubble … ?
On the other hand that p/e was well below the 45.5x reached at the market peak of 2007 – a peak which has yet to be exceeded. And it is miles short of the 60-70x levels seen during the twilight of the go-go 1990s tech boom, and below the average level so far this century. In addition, +53% is only the fourth-highest calendar year price return for the index in the last ten years, the highest having been seen in 2006 when the market much more than doubled. Finally, the market was valued at under 10x earnings for long stretches of 2013-14 before the rally began, well below the 14x and 12x reached at the market bottoms in 2005 and 2008.
This is a febrile market which has undergone rapid change but to interpret its rally from the depressed point of mid-2014 as an egregious bubble episode is to make a glaring analytical mistake.)
Some of the actions of the Chinese government have been woefully unhelpful. Direct interventions in the stock market have exacerbated falls and sharpened investor concerns, as tends to be the way of these things. At the same time, special interests in the corporate sector have sought to manipulate the government’s response to their advantage.
Other parts of the world were in exactly the same place very recently. The SEC banned short selling of financial stocks on Wall Street from Friday 19 September 2008 – the week of the Lehmans bankruptcy – in an effort to “protect the integrity and quality of the securities market and strengthen investor confidence.” By the time the ban ended after the close on Wednesday 8 October the S&P 500 Diversified Banks index had fallen by another 22%. Christopher Cox, then Chairman of the SEC, gave an interview to Reuters after Christmas that year which contained the following little nugget:
Cox said the chief executive of one major U.S. investment bank even urged suspension of normal trading rules across the entire U.S. market, likening the situation to how Abraham Lincoln suspended habeas corpus during the Civil War and Franklin Roosevelt sent Japanese-Americans to internment camps during World War Two.
The chief executive said, “that is how America made it through such crises, and we couldn’t be too focused on maintaining the rule of law,” Cox said.
Now that is panic. When it hits markets it is perhaps understandable that policymakers are not immune.
At the same time as the SEC was floundering around trying to put the clock back, however, the US Treasury began to implement measures under the newly-enacted Troubled Asset Relief Program, including the purchase of mortgage-backed securities to assist in the repair of bank balance sheets. On 8 October 2008 the Fed cut its target rate for the first time since April of that year from 2% to 1.5% in a concerted move with the ECB, Bank of England and the central banks of Canada, Sweden and Switzerland. A month later it began its first tranche of bond purchases under QE.
The speed of the banking sector recovery in the US – as opposed to Europe or the UK – has been one of the great relative strengths of the American economy. While some actions of the American government were woefully unhelpful, therefore, others were more constructive.
Exactly the same is true of the situation in China today.
As this blog remarked over the summer, it had been ignored amid all the attention on stock markets that China’s exporters were being hobbled by the quite sudden strength of her currency against the euro (and, for that matter, the yen). Only a few days after that post was published the People’s Bank of China devalued the yuan by 1.9%, its most significant depreciation since the epoch-making 50% shift engineered in January 1994. By the end of the week the yuan was down all of 2.9% at 6.39 and has stayed close to that level ever since. A few days later the 12-month benchmark lending rate was cut, for the fourth time this year, and a further reduction in the required deposit reserve ratio announced for major banks. At this point the PBOC had fired all three monetary weapons in its arsenal in a single month.
Back in the 1990s China came to dominate production in certain low-technology sectors, such as toy manufacture, and remained a relatively small economy (still smaller than Italy by the end of the century). Through continued competitiveness, investment, innovation, and broadening into higher-tech areas such as computers and mobile phones, Chinese exports overtook those of the US in 2007 and of Germany two years later. Today China is the world’s largest exporter by a mile, with the annual pace running at $2.4trn versus $1.6trn for the US; fifteen years ago China exported about a quarter as much as the US did.
So exports matter to the Chinese economy, devaluation ought to help exporters, and monetary softening elsewhere ought to ease some of the pain in the property market and contribute to lending growth. All this is fundamentally supportive. Nonetheless, the devaluation in particular – arguably the least contentious policy response of all – was interpreted as a sign of panic and the stock market continued to fall. In other words the actual direction of monetary policy was ignored in favour of the presumed context for its loosening. This was obviously a bearish response which again has clear recent parallels elsewhere.
What must surely be only a little less obvious are the implications of this response for imminent policy action in other places. Mr Carney at the Bank of England has just dismissed the idea that the kerfuffle within and over China will throw the MPC off their envisaged tightening path for rates. In the US, speculation over the timing of the first hike in the fed funds target since June 2006 has reached fever pitch. Will it motor up to 0.5% in two weeks’ time, as the majority of forecasters currently expect? Or will there be a delay?
Most importantly for investors: would a September hike be taken as evidence of a strong recovery, or would it ignite fears that the Fed is taking away the punchbowl too soon? And would delaying until next month be seen as a welcome reprieve, or betray a conviction that the US economy’s expansion is weaker than was thought?
The consensus from market participants still seems to be that monetary tightening will be accompanied by the upward march of equity benchmarks because (a) tighter money is a sign of economic strength and (b) that’s what happened last time. But as the events of recent weeks have shown, markets can get nervous again very quickly. And the Chinese experience is a reminder that in those circumstances, even positive policy decisions are taken as a sign of something bad.
It is difficult – even, perhaps, irrational – to dislike stocks more today than before they tumbled. There does not appear to be a new recession suddenly lurking around the corner. But complacency over the ability of today’s stock markets to take higher rates in their stride sits uneasily with the reaction to China’s very modest devaluation and other policy manoeuvres.
The ongoing drama over Greece continues to monopolise the financial world’s attention. We will probably find out how it ends – for the time being – in a day or two. In the meantime it has been easy to lose sight both of other potential sources of political risk and of the macro and market undercurrents which as rational investors we of course believe will come to dominate in the end.
Political risk is a difficult measure to quantify and a shock, by definition, cannot be planned for. However we have had some horrible reminders today that terrorism is grievously on the rise. This morning it was the attack on a factory in France; then a bombing in Tunisia; and a suicide attack on a Kuwaiti mosque during Friday prayers. These acts have all been claimed or inspired by the Islamic State.
The growing confidence and appeal of IS became glaringly obvious at the time of the Charlie Hebdo atrocity in Paris. Concerns have mounted since at the numbers of Muslims in European and other “western” countries who have tried to join IS in the Middle East, and who it is feared have been returning to shed blood in their homelands thereafter. And competition between IS and Al-Qaeda has been escalating in an attempt to establish leadership of global jihad. The rise of terrorism and the occurrence of any attack is lamentable but it is this last point which poses the risk to markets: something on the scale of the Bishopsgate bombing of 1993 or the 9/11 attacks eight years later has become a strategic goal for terror.
Meanwhile, the collapse of peace talks over Yemen last week has seen renewed Saudi bombardment of the country as the civil war there grinds on: the war doubles as a proxy conflict between the Saudis and Iran. Internal Yemeni rivalry between Al-Qaeda and the Islamic State is a complicating factor, as is the US drone campaign there against the former (though this is supposed to have been suspended in recent months). Elsewhere, negotiations continue to secure a commitment from Iran that she will not become a nuclear power; there is little encouragement to date that their objective will be achieved. In other words, the perpetual powder keg which is the Middle East has been getting even more alarming this year.
It seems reasonable to conclude that the risk of short-term setbacks to risk assets has increased in 2015. But what of the underlying fundamentals?
Here the picture is more mixed, which is to say, more positive overall. Attempts have been made to portray some of the major equity markets as dangerously overvalued but they do not stand up to balanced scrutiny. The economic outlook has disappointed in some places – most conspicuously in the US – and improved in others, such as in Europe, where even the threat of a Greek default has not noticeably dented confidence this month.
One area which has seen some movement this quarter has been the safe haven bond markets. There has been a marked sell off. The ten year gilt yield has risen by 60bp, the ten year US Treasury yield is almost 50bp higher and the ten year German bund yield is up by 70bp, having reached a low of 0.075% as recently as April. Upward moves in interest rates from the Federal Reserve, and with more of a local impact the Bank of England, have been drawing nearer for some time. The futures markets are currently pricing in a 25bp hike from both towards the end of the year. By then the disinflationary impact of last year’s fall in the price of crude oil will have unwound completely. Indeed, should the price rise between now and December then energy will become a source of inflation again.
Bond markets have a long way to go in many places, including here in the UK, before they start to close the valuation gap with equity. The earnings yield on the FTSE All Share Index is still almost three times the gross redemption yield on the ten year gilt, having averaged 1.8x over the last 20 years and 1.1x in the decade prior to the credit crunch in 2007. To reach those levels again the gilt yield would have to rise to 3.5% or 5.8% from 2.2% today. Furthermore, stock market observers seem pretty convinced that markets will take the early phase of rate hiking in their stride, largely because this is what happened last time. They might well be right – but this is not how things went the time before that (1994 as opposed to 2004) and since rate rises are such a novel idea these days their rediscovery surely poses some measure of risk.
So while the threat of short-term shocks has increased the possible medium-term headwinds from monetary tightening have been blowing closer too. It is doubtful whether most major stock markets are in bubble territory and likely that economic and reported earnings growth have much further to run. But selling on the records rather than buying on the dips appears the more rational approach at this point in time.