As we enter the second half of 2019, major developed world central banks have struck dovish tones indicating that rate cuts and other forms of policy stimulus are on the horizon due to low realised inflation, slowing growth, and geopolitical uncertainties.
While keeping policy rates on hold at a range of 2.25%-2.50% after its June meeting, the US. Federal Open Market Committee (FOMC) revealed through its June dot plot that seven out of its 17 voting members expected the federal funds rate to end the year 50 bps, or 0.5%, lower than current levels. While the median projected rate at the end of 2019 remained unchanged at 2.25%-2.50%, it was forecast to drop by 25 bps by the end of 2020. In contrast, no voting member at the end of the March FOMC meeting expected policy rates to fall in 2019, and by the end of 2020, the median projected rate was actually forecast to rise by 25 bps from current levels.
The increasingly dovish stance taken by the FOMC has been due to a combination of factors including realised inflation rates falling below the Federal Reserve’s 2% PCE target (core PCE was 1.6% year over year as of May), muted business investment indicators, and continued geopolitical uncertainties stemming from trade tensions between the US and its trading partners, including China and the EU. The increasing dovishness of the Fed has helped US 10-year bond yields fall from close to 2.70% at the beginning of the year to 2%.
In Europe, at the European Central Bank’s (ECB’s) recent annual forum in Sintra, President Mario Draghi also raised concerns over economic risks and inflation remaining below the ECB’s inflation target. He indicated that further cuts in policy rates (the deposit rate is currently negative at -0.40%), along with additional central bank asset purchases, were possible. His comments helped German 10-year bond yields fall to -0.40%, a new all-time low. The impact of trade tensions has been particularly pronounced in Germany, the EU’s largest economy, with manufacturing activity declining due to falling business investment amid trade uncertainties, a slowing global economy, and concerns over a no-deal Brexit.
While bond markets currently portend slowing economic growth – indeed the three month 10-year yield curve remains inverted in the US (often a precursor to a recession) – several stock markets, such as the S&P 500, are near all-time highs, with the S&P 500 trading near 3,000. While falling bond yields decrease discount rates, and therefore increase the present value of expected free cash flows generated by companies (in other words, increase the fair value of share prices), it will take more than lower discount rates and central bank asset purchases to support risk assets.
If expected cash flows are a function of expected revenues and expected expenses, then expectations matter. In a world where prices of input goods are expected to rise due to tit-for-tat tariffs levied on trading partners, and/or revenues stemming from business investments are expected to fall (e.g., due to economic uncertainties among purchasing managers) expected cash flows, all else equal, and consequently share prices should fall. Thus, supporting spending, whether by corporations, governments, government-sponsored entities, and/or households, is essential.
A key contributor to spending decisions is consumer and business confidence. In an environment of increased uncertainty, spending confidence decreases. Lower interest rates, or at least expectations that interest rates will remain lower for longer, give borrowers increasing confidence to spend with the hope that incremental spending financed by lower expected debt-servicing costs will not leave them insolvent or illiquid. In addition, central bank asset purchases can also lead to increased spending through wealth effects resulting from higher portfolio values (a richer person whose assets have been propped up by central bank purchases feels like spending more). Thus, while central banks can do little to offset the higher costs of goods emanating from increased tariffs, other than perhaps making exports cheaper by engineering currency devaluations through forward guidance (but this is often matched with competitive currency devaluations induced by peer central banks), they can seek to increase consumer and business confidence while lowering the cost of borrowing. Higher spending, in theory, should help central banks meet their inflation mandates.
Citing the example of Japan, critics argue that lower interest rates will not lead to increased borrowing and spending because US households and corporations are in a balance sheet recession and are focussed on deleveraging. US households have indeed been deleveraging since the 2008 financial crisis. However, they now have additional room to borrow and spend, provided that consumers remain confident (personal consumption represents 70% of US GDP making consumers a potent economic force). Total credit to non-financial corporations as a percentage of GDP has exceeded previous highs seen in 2008 and critics argue that corporations will be reining in borrowing. However, as seen in the graph, debt levels of US non-financial corporations are nowhere near the levels experienced in Japan in the 1990s, and while not a perfect comparison, the graph suggests that US corporations may have additional room to borrow to fund share repurchases or, even better, invest in the real economy, thus potentially increasing productivity.
Thus, all else equal, additional central bank stimulus should support risk assets provided that nothing else goes wrong.
So what can go wrong? 1) We could have a disorderly Brexit which could negatively impact growth in the UK and neighbouring economies. 2) The US-China trade dispute could escalate leading to higher tariffs and non-tariff barriers and therefore higher input prices. 3) Christine Lagarde, the new ECB President nominated to replace Mario Draghi in November 2019 could be less dovish than expected by market participants. 4) Tensions in the Middle East could rise leading to higher oil prices; the list goes on.
Judging from the evolution of several risk assets since 2009, investors have often been rewarded for ignoring risks, especially with the support of central bank stimulus. Share prices can and do deviate from their fair values due to a number of factors beyond central bank stimulus including demand levels for liquidity and behavioural dynamics (i.e., level of investor risk appetite). Some would argue that US share prices today, on average, are above their fair values.
Central banks are not willing to be the only game in town and have long urged for the baton to be passed on to governments which can help to support economies through fiscal stimulus (especially if consumer and/or business spending falls) and economic reforms; indeed, the marginal utility of central bank stimulus is, by definition, fading.
While governments continue attempts to implement reforms, voters often punish elected officials who try to implement them, and generally are not willing to take pain for past excesses, especially when they did not participate in those excesses. Productivity growth is one way to offset the pain of much-needed reforms and help economies reduce debt. However, until productivity growth increases, it will be hard to square the circle. In its absence, central banks and governments will need to enact mutually reinforcing policy measures that support the economy and, by extension, risk assets. There is little room for error.
Sources: Bloomberg, Forbes, Financial Times, St. Louis Fed Database, US Federal Reserve. Nurmohamed is an investment management professional for the Butterfield Group. Disclaimer: The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.