“The Message” Dr. Dre, 1999
Recent global central bank meetings have revealed a common message: a weaker economic outlook and lower inflationary pressures justify a pause in the monetary policy normalisation process.
The clarity of the message helped financial markets to stabilise, as the January rebound of risky assets illustrated. However, it raises questions about future asset returns and asset allocation. Are we back in “beta party” territory, where bad news is good news thanks to central bank support, as observed between 2010-2017? Or are we moving into a classical “bad news is bad news” scenario, where macro volatility surges and increased recession risks cannot be stopped by easier monetary policy.
When central banks deliver the same message…
Looking forward, there are scenarios where the next move in the cash rate is up and other scenarios where it is down. Over the past year, the next-move-is-up scenarios were more likely than the next-move-is-down scenarios. Today, the probabilities appear to be more evenly balanced.
Last year, guidance from key central banks, such as the Fed, ECB, BoE, Riksbank and Norges Bank, was similar and well telegraphed. With a positive economic outlook, wage growth on track and financial markets stable, after years of support, monetary policy normalisation should be the next step. Responding to this message, money markets expected higher short-term rates across the board. In October 2018, expectations were for a first hike in Europe in Q3 2019, two new hikes in the US, Sweden and Norway in 2019 and at least one hike in the UK.
Three months later, the monetary policy landscape has completely changed. The Fed has been the first one to modify its stance from restrictive to neutral. Others have followed, signaling that downside risks have increased sharply. Last week’s communication from the Reserve Bank of Australia summarises this U–turn perfectly: “Looking forward, there are scenarios where the next move in the cash rate is up and other scenarios where it is down. Over the past year, the next-move-is-up scenarios were more likely than the next-move-is-down scenarios. Today, the probabilities appear to be more evenly balanced.” The message is clear: for most central banks, the odds of a cut in interest rates have increased markedly and now have the same probability as a hike.
It’s a clear game changer for financial assets and money markets have now significantly reversed their expectations: a cut in the US, Australia and New Zealand in 2020 and no hikes or postponed hikes elsewhere, except in the Nordic countries. Emerging markets are in a similar situation, as highlighted by last week’s rate cut by the Reserve Bank of India. Pricing in Brazil and Mexico also suggests a shift from hikes to cuts.
…the best thing to do is to listen
Since the financial crisis, central banks have played a new role, shifting from “market stabiliser” to “market maker”. With unconventional monetary policy and balance sheet use, they have impacted financial prices more directly than in the past. The Bank for International Settlements has documented the new monetary channels implied by this new framework, including “balance sheet” and “portfolio channel”. Therefore, when the main market players talk as clearly as they do, the best thing investors and financial markets can do is listen.
In January, they did listen and modify their pricing, firstly in terms of the recession probability. Elevated at the end of December, this probability receded in January thanks to the market recovery and the central banks’ U-turn. Less restrictive monetary policy is indeed supportive for valuation and lowers sharply the risk of monetary policy mistake. We have even observed some reminiscences of a “Goldilocks” context, where stable growth and low inflationary pressures represented the best environment for asset returns. As an illustration of this belief, the traditional balanced portfolio (50% global equities/50% global bonds) in January delivered its best monthly performance since 1990. Does this mean that bad “economic news” is good news for asset returns? And should we re-risk our portfolio to leverage the benefit of this favourable context for beta?
This time could be different
That could be the temptation if we analyse the recent episode of central bank support. Indeed, the correlation between the change in the aggregated balance sheet of central banks and the return of risk assets has been high over the last decade. Historically, central bank action has had a positive impact when balance sheets of corporates and households have had to be repaired; asset prices are depressed and market sentiment very pessimistic. Easing financial conditions allow increasing valuations, smoothing the negative effects of balance sheet reduction, improving the economic outlook and market sentiment in turn.
However, today is different. Firstly, the economy is deteriorating, which is very different from a “Goldilocks” scenario or in periods of quantitative easing, where we were at the trough of the economic cycle. Secondly, according to our valuation indicators, growth-oriented asset valuations are much higher than they were when central banks used their monetary tools between 2008 and 2015. Moreover, in the past, central bank intervention happened when volatility was high and significantly higher than today. Therefore, expected returns would be much lower this time. Thirdly, when “bad news is good news” has worked, the “surprise effect“ of new tools implemented through an unconventional monetary policy framework has amplified the benefits from both the “balance sheet” and “portfolio” channels. We believe that this time the transmission of new easing would therefore be weaker. Finally, and this is a key issue for central banks such as the ECB, SNB, Riksbank and BoJ, their ammunition is much smaller than in in the past because they haven’t removed their accommodative stance, maintaining negative interest rates and large balance sheets despite cyclical improvements.
As a result, we are maintaining our cautious asset allocation stance despite the clear message from central banks. In our opinion, any potential central bank action will not be sufficient to offset the macro deterioration that our Nowcasters are highlighting.
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