The mood was positive in Washington DC last week, where the Annual Meetings of the Boards of Governors of the World Bank and the International Monetary Fund took place. With the backdrop of a broad-based upswing in global growth coupled with low inflation, the environment for risky assets remains strong. However, complacency was not in evidence; during the various panels I attended, different tail risk scenarios remained central to discussions, and many comparisons were drawn with the 2006/7 period. Below I share some of the key takeaways for investors.
Global growth backdrop remains positive
The IMF upgraded its global growth forecasts and is now focusing on the issue of sustainability, pointing to the issue of climate change as a determinant of economic outcomes in its World Economic Outlook. It is also urging key central banks to go slow when it comes to monetary policy tightening in order to avoid any destabilising effects against a backdrop of still-subdued inflation.
All eyes on the Fed – who will take over as Chair?
Kevin Warsh seems to be favourite, albeit marginally, to be the next Chair of the US Federal Reserve. Warsh is closely followed by Jerome Powell, with incumbent Janet Yellen seeming to lag behind both. On the surface, Warsh appears more hawkish than the other two, but this conclusion seems largely based on an old analysis of Kevin Warsh's views. Some argue that there is little difference between the three regarding the general direction of policy they would take if they became Chair. John Taylor (of the Taylor rule – which relates to the setting of interest rates) is the wild card and he met Trump recently.
US monetary policy tightening – slow and steady
The tightening of monetary policy by the Fed is broadly expected to be gradual, predictable and linear as inflation remains low. Indeed, there was continued talk of a “new normal” resulting from a downwards shift in the Phillips curve (describing the inverse relationship between unemployment and inflation). If proponents of this theory are correct, interest rates – and unemployment – could remain low without creating inflationary pressure. However, the Fed’s focus currently seems to be relatively more on financial stability (fearing markets overheating) than on inflation, paving the way for a gradual reduction in its balance sheet and gradual rate hikes. This explains why December seems inevitable for the next rate rise, despite the latest inflation data coming in below expectations.
US tax and trade – scepticism is rife
Investors remain sceptical over the implementation of US tax reforms given how Trump has loaded up Congress’ agenda (eg, the Iran deal is now being pushed to Congress). In my view, given the mid-term elections we may see fast progress on this early next year, and this is currently not priced in by the market.
On trade – specifically the NAFTA renegotiations – there is a general mood of pessimism as the US continues to take a tough stance, with the probability of no deal rising, although it will take months before clarity emerges.
Europe – no longer the developed world’s problem child
In Europe, there was a general sigh of relief following the outcome of various elections and in light of the strong growth upswing. That said, the outlook for reforms to the EU points to very incremental change, based on comments from various senior figures; despite Macron laying out an ambitious plan, a weakening of Merkel’s position post-elections appears key. For once, however, Europe is not seen as source of immediate risk.
Eurozone monetary policy – continued support for growth as inflation remains low
The consensus is that any move away from the ECB’s current accommodative monetary policy stance will be gradual, and news flow in recent days appears to confirm this. Questions around debt levels and rising populism were largely avoided and the overall message seems to be: enjoy the recovery, and the central bank will support this given the subdued inflation environment.
Bank of England and Brexit
Here’s where the picture becomes less rosy. The Bank of England is sounding very hawkish with its latest rhetoric focusing on a supply-side shock to the economy owing to Brexit, which has lowered potential growth thus necessitating a hiking cycle. The UK is generally seen to be a in tough spot in Brexit talks.
The “Mystery of Inflation” and the Phillips Curve
Broadly, there seems to be no consensus over how any scaling back of quantitative easing will affect inflation, given how moderate it has been despite the fall in slack in the economy. Indeed the lack of concrete or consistent views on the topic among central bankers is somewhat unsettling. The monetary stock and flow effects of quantitative easing and their relative importance were discussed widely in various panels, with senior policy makers still reluctant to abandon inflation targeting or the Phillips curve (the relationship between unemployment rate and inflation). Globalisation and the Amazon effect (eroding the margins of retailers by increasing international competition) together with a high level of involuntary part-time employment were discussed as various factors behind the demise of Phillips curve.
According to our analysis, there is visible evidence that the traditional Phillips curve has changed in the US. However, the relationship between equity market valuations (proxied by the cyclically-adjusted PE ratio compiled by Shiller) and the unemployment rate – a relationship which we denote as the “Investors’ Phillips curve” (or “iPhillips curve”) – seems to be very much intact (see below). We intend to share a more detailed analysis on this topic in coming days.
On emerging markets – positive but not complacent
The general consensus on emerging markets is positive; these economies are broadly seen as being in much better shape than in 2013 (taper tantrum) but there were warnings against complacency especially on the fiscal side as budget deficits have generally increased. Local currency investments remain the preferred choice over dollar-denominated, and emerging market equities are still in favour.
Geopolitics – uncertainty over North Korea
The US seems to be viewed as the more unreliable party in the conflict with North Korea, with the latter considered to be dangerous but rational. An accidental war under Trump remains a key risk with markets struggling to decide how to price in such a binary risk. China is seen as being in a tough spot and an oil embargo is viewed as unlikely for now as that would be seen as act of war.
Japan – reform and ageing
Shinz? Abe is widely seen as winning the next elections, with constitutional reform top of agenda. The Bank of Japan is expected to maintain the status quo as the 2% inflation target is gradually abandoned over coming years. There was an intense discussion over how ageing interacts with economic policy.
Cyber Security and oil markets
Cyber security was a new theme at these meetings with concerns raised around the fast digitisation of the financial sector and the vulnerabilities it creates, especially given the rise in state-based cyber interventions.
Regarding oil markets, the US-led damage to the Iran deal and rising tensions in Kurd-dominated territories are seen as creating upside risk at a time when the market for oil is becoming more balanced as supply falls and demand continues to post steady gains.
The Washington meetings were consistent with our positive views on European equities and emerging markets (both equities and local currency debt) while underscoring the importance of vigilance: investors should beware a number of tail risks and uncertainties in the monetary policy space, especially as there seems to be little consensus on how the unwinding of quantitative easing will impact risky asset performance going forward. So far, the Fed has managed well the signalling effect of balance-sheet normalisation, but with the ECB poised to slow purchases, net central bank liquidity is set to become negative for the first time in years in the second half of 2018.
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