James Bevan: Central banks, policy challenges and investor concerns
0Central banks have been very supportive of the bull market since 2009, providing exceptionally easy monetary policy to facilitate economic growth.
Near-zero interest-rate policies and quantitative easing programmes have worked to drive stock prices higher with the likely expectation that the positive wealth effect would boost consumer spending.
That worked well for stocks (at least) until last year but since May 2015 investors have been increasingly fretting that these policies seem to have lost their effectiveness in boosting both stock prices and economic growth.
That’s because more investors seem to be wondering if the major central banks have run out of policy options. They are also wondering why the global economy is so weak and inflation so low after so many years of very easy monetary policy.
Concerned bears
Recent bear concerns were summarised by Allianz’ Mohamed El-Erian on 8th January: “The bigger issue for financial markets is that central banks are running out of ammo.
“Markets are realizing that central banks can no longer repress financial volatility. And they are repricing to new volatility paradigm.
“What we’re going to see is every time something happens in the world it’s going to take longer to restore stability.”
With so much having already been done to encourage growth since the global financial crisis with interest-rate cuts, tax cuts and more spending, it’s hard for the authorities to do more, and indeed the minutes of the ECB’s 2nd/3rd December meeting (released on 14th January ) showed that the committee rejected the idea of expanding and extending its QE programme:
The possibility was also raised of expanding the monthly volume of purchases or, alternatively, of frontloading purchases within the envisaged envelope so as to strengthen the impact in the short term.
Moreover, the option was raised of extending the horizon beyond the suggested six months, so as to increase the overall volume of purchases. … However, there was broad agreement that such measures would not be warranted at this juncture, while a reassessment could be made in future.
Then last Friday, the Bank of Japan’s Haruhiko Kuroda said he had no plans to expand monetary stimulus now, blaming sharp declines in oil costs for keeping CPI inflation well below the bank’s ambitious 2% target.
However, he did say that the BOJ would ease monetary policy further if risks threaten achievement of the price target.
On Monday, in a quarterly report on Japan’s regional economies, the BoJ commented on the slow pace of wage increases nationwide: “Many small and medium-sized companies in regional areas remain cautious of raising regular pay for permanent employees.”
The BoJ went on to say, “…momentum towards raising salaries next fiscal year has failed to gain steam,” mostly because employers are wary of a shrinking domestic market and global uncertainties.
Over in the US, in early January, Fed vice chair Stanley Fischer said the Fed should be open, in the future, to raising interest rates to ward off potential asset bubbles but meanwhile the US is experiencing very low inflation due to falling oil prices, the strength of the dollar and weak growth in wages.
Thus while the US unemployment rate has been running close to the 5% level that the FOMC considers to be the ‘natural rate’ since last August, the committee’s preferred inflation measure, the core Personal Consumption Expenditures Deflator (PCED), has been running below their 2% target since May 2012 and was just +1.3% year on year through November.
Furthermore, wage inflation has also remained more subdued than widely expected now that the jobs market seems to be relatively tight.
Oil
On the oil front, the Fed’s Bullard has calculated that if oil prices had stabilized around $40 while all other prices continued to increase at the same pace as 2015, the headline CPI would be at more than 2% in 2016 but if oil stabilized at $20 by June 2016, CPI inflation would rise only 0.6% in 2016, and not reach 2% until mid-2017.
On the dollar, there is an inverse correlation between dollar strength and expected inflation, and non-petroleum import prices were down 3.7% year on year through December and import prices are highly correlated with the core intermediate PPI, which is down 3.6% year on year.
With regard to wages, Fed officials, especially Fed Chair Janet Yellen, strongly believe in the Phillips Curve model of inflation and with the unemployment rate low at 5%, wages should be rising faster, resulting in higher cost-push inflationary pressure on the core PCED.
But globalisation of competition and technological innovation have kept inflation down, whilst falling oil prices have depressed inflation expectations, which has also kept a lid on wage inflation.
As Mrs Yellen said at the Fed’s 16th December press conference: “Monetary policy is based on economic forecasts.
“There are theories of how the economy works that govern many aspects of economic forecasting. Whether it’s consumer spending or residential investment or inflation, the underlying theories are not perfect, and they are subject to uncertainty. And this is true in all aspects of forecasting, which is why we change our forecasts and our models.”
As things stand, the Fed doesn’t see inflation reaching 2% until 2018. Before that, the median inflation projection is expected to increase from 1.6% in 2016, to 1.9% in 2017.
In effect, the FOMC hopes that inflation will rebound after oil prices stabilize and the effects of the strong dollar wash through. This is why there is increasing focus on what else can be done.
Governments may well end up spending more in absolute or relative terms, either by design or because claims rise relative to tax take. But the real challenge is supply-side reform to promote efficiency and productivity and rebalance economies.
If that nettle is grasped, the outlook is great. If it isn’t companies with strong and reliable revenues, margins and growth will be increasingly sought after. Either way, when the turbulence subsides, the equities of great companies, now at cheap prices are well placed.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
*CCLA is a supporter of Room151
