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A sobering thought: a party without a punchbowl?
According to William McChesney Martin, the longest-serving (1951-1970) Chairman of the Federal Reserve, it is central banks’ job to “take away the punchbowl just as the party gets going”. The current party has been a pretty subdued affair, and that punchbowl has had to have some unconventional contents, but at some stage, as usual, investors are going to have to face the future clear-headed.
That stage is probably still some months away. The eurozone economy is still best described as flatlining. The UK economy has only just escaped its possible ‘triple dip’ (whether it would have been a meaningful dip is another matter). China has yet to convince that its structural deceleration is behind us, and Japan to demonstrate that a structural acceleration lies ahead. Meanwhile, the US economy faces a second quarter slowdown, with unemployment still a percentage point above the level at which the Fed has said it will start to take a more hawkish line.
Figure 1: The trend in US consumer spending may have little to do with QE
But as we see it, the economic debate is slowly moving on. The euro crisis has failed to flare up again (we’d thought it wouldn’t) in the face of setbacks in Italy and Cyprus, and the latest eurozone business surveys show activity stabilising (albeit at low levels). The short-term data at least in both China and Japan have been encouragingly resilient. The last month’s news has shown that the US consumer – still customer number one for global business – is clearly capable not just of “life after debt” but also of “life after Reinhart and Rogoff”, and in the meantime the US government’s deficit has been shrinking far faster than the pessimists had imagined, loosening another potential brake on growth in the cycle ahead. Even the Governor of the Bank of England has been sounding relatively cheerful of late, though he may of course be demob happy.
This should be good news for businesses and people, if bad news for bonds. But not all pundits see things quite this way. Many argue that the progress made to date is entirely down to the special measures – negligible interest rates and bags of quantitative easing (QE) – taken by the major central banks, and that if these are withdrawn, we’ll rapidly return to the brink of the abyss we escaped in early 2009.
“Recovery has coincided with QE, but is not necessarily the result of it. Correlation does not imply causation”
We think this is too pessimistic. To extend the party analogy, we think it is possible for investors to have a decent time sober. The resumed post-crisis growth in economies and profits has coincided with ongoing QE, but has not necessarily been caused by it. In some instances, very visibly it can’t have been. For example, the bulk of the rebound in US corporate profits has simply reflected the arithmetic contribution from the ending of financial sector write-downs, which had nothing directly to do with QE. The surge in Japan’s GDP in the first quarter of this year, we would suggest, is unlikely to have been driven by the admittedly impressive wave of pending QE announced in early April. More generally, the trend traced by the level of nominal US consumer spending has been virtually indistinguishable to the naked eye from that traced immediately ahead of the monetary seizure triggered by the collapse of Lehman in 2008.
The perma bears may have overlooked an important fact of economic life. Growth is the norm, not the exception, and in the long term is driven by real magnitudes – the labour, resources, technology and organizational know-how at our disposal – and not by financial balance sheets (which in any case are not as fragile as feared).
For sure, QE – and lower interest rates – helped to save the financial world back in the crisis: if central banks hadn’t acted as they did, monetary collapse and Depression might well have loomed. But to attribute all of the recovery since then to their continued support is a little like saying that the crash barriers that prevent you from leaving the road are responsible for you making headway along it. At the risk of stretching the metaphor beyond breaking point, central banks’ stance currently is not quite economic life support, and the patient will be capable of surviving it being switched off.
This theory is probably not going to be put to the test soon: we see interest rates staying on hold for many months yet, and US and Japanese QE continuing into H2 (indeed, the bank of Japan has of course really only just begun its new, revamped QE). When the support is withdrawn, however, some market volatility is likely – sufficient for us to anticipate trying tactically to reorient investor portfolios ahead of it.
Figure 2: Money market futures show rates starting to rise in a year’s time
We do not expect the sort of dramatic, prolonged reversal that followed the last two stock market surges, which peaked in 2000 and 2007. As noted, QE is only partly responsible for stocks’ rally. Valuations are lower now, and there are surely fewer excesses in the system. Moreover, if we disentangle current yield curves, we can see that some normalization is of course already firmly priced-in to money markets: forward curves in the US, the UK and even the more sluggish, disinflationary eurozone show forward interest rates starting to rise in around a year’s time.
Nonetheless, it will likely be a bumpy ride, particularly if central banks act sooner than the money markets currently expect. This will add to the already striking parallels with the mid 1990s. Then, a tightening of policy by the Federal reserve had a potent tactical impact on both bond and stock markets, before investors settled down to the realization that the global economy could indeed continue to grow. Around the same time, as now, we saw developed markets and the dollar assume cyclical leadership from the emerging world and commodities – trends that are already reflected in our current investment advice.
Meanwhile, beyond the probability of a short-term chart-driven pull back, our advice is again unchanged this month. Developed equities remain inexpensive, and until central banks take that punchbowl away a more meaningful tactical setback still feels unlikely. Being tactically overweight stocks, remember, doesn’t mean we expect them to continue to rise apace – simply that we think their risk-adjusted 3-6 month returns will exceed those on other assets. Since equity yields are higher than on most other assets, this can happen even if prices do little more than mark time in the rest of 2013 – particularly if, as we expect, some fixed income assets actually fall in value.
Barclays’ key macroeconomic projections
Figure 3: Real GDP and Consumer Prices (% y-o-y)
Figure 4: Central Bank Policy Rates (%)