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Market View

Why monetary policy matters more to investors than Trump and Brexit

A PDF version of Market View is available.

A roller-coaster news agenda has failed to destabilise markets so far this year. Even the threat of a nuclear war has failed to dent market confidence. It goes to show that when conditions are good, the market can choose to ignore whatever ‘catalyst’ presents itself. In more cautious times, that catalyst might have a bigger impact.

Investors have started to lose interest in the Brexit and Trump soap operas, and are paying closer attention to the normalisation of monetary policy and how that will play out over the coming months. While the scale of quantitative easing in 2008/9 was a departure from the economic status quo, removing it after almost a decade is equally as significant. Now that economic growth is picking up in the world’s three most important economic regions – the US, China and Europe – central bankers have signalled that they will gradually wean the economy off the drug of easy monetary policy, and the US is leading the charge.

Wiping trillions of dollars from the US balance sheet

When the financial crisis struck in 2008, the US Federal Reserve (Fed) aggressively cut interest rates and injected capital into important markets that investors were too scared to touch. It’s generally accepted that this decisiveness prevented a depression. Over the years that followed, the Fed bought around $4.5 trillion dollars of government and other bonds, which equates to 25% of US GDP. As these bonds have matured, the money has been reinvested into similar bonds, keeping the size of their investment roughly constant, and having a neutral impact on the market – until now.

Starting this month, the Fed will start to reduce the amount it reinvests, gradually reducing the size of its holdings by $10 billion per month, which will steadily increase until it reaches $50 billion per month. This won’t surprise markets in the immediate term, but no-one really knows how it is going to play out in the coming years. Our best guess is that by buying these bonds in the first place, the Fed forced bond yields lower, making it more attractive for companies to borrow money and grow the economy in the process. So, reversing this should have the opposite effect, pushing bond yields up.

Will Japan, the UK and Europe follow suit?

Europe and Japan are some way behind the US on the path to normal monetary conditions. Indeed, they are still buying bonds. Japan is likely to continue doing so for some time as their recovery is still very weak, but we expect the European Central Bank (ECB) to announce plans to ease off its quantitative easing program. Who knows, maybe this time next year the ECB will be talking about their first interest rate hike, if you can consider going from minus 0.3% to zero a hike!

The Bank of England is pre-occupied with rising inflation, hinting it will increase interest rates before the end of this year. We’re concerned that an interest rate rise is premature. Inflation is simply a function of the weak pound, and should return to the bank’s target level of 2% without their help. Again, time will tell.

“Notwithstanding current geopolitical risks, and concerns over market valuation, support for equities comes from the steady and non-inflationary pace of global expansion. Measured monetary tightening, if done properly, should not get in the way.” - Philip Smeaton, Chief Investment Officer

The outlook for inflation

It’s the consensus view that global inflation is likely to stay low for the foreseeable future. We think this makes sense, but holding the consensus view means we must be extra careful not to be caught in a stampede when everyone is changing their mind at the same time. After all, as the graph below reminds us, this isn’t the first time that a benign inflationary environment has changed quickly.

US Core inflation has changed direction sharply in the past

Source: Bloomberg

Nevertheless, there are good reasons to think that inflation will remain near the 2% target:

  • Central banks will be quick to act if inflation rises, in fear of it destabilising the economy. Indeed, the Bank of England is already demonstrating discomfort, despite the fact inflation is far from out of control.

  • There is limited evidence to suggest that low unemployment rates will lead to inflation (through increased wages).

  • Commodity prices suggest continued moderate levels of inflation.

  • The impact of technology and an ageing population are still factors in keeping inflation low. Technology makes things cheaper, and an ageing population means less demand.

“It’s disappointing to see the Bank of England lose confidence in its post-Brexit actions. Concerns about high levels of inflation means it is likely to hike interest rates. But we think high inflation is simply a case of companies passing on the effects of a weaker pound, and that this effect will dissipate over the course of the next 12 months, regardless of the Bank of England’s actions.”Matthew Brittain, Investment Analyst

A PDF version of Market View is available.

This article is for information purposes and should not be treated as a forecast, research or advice to buy or sell any particular investment or to adopt any investment strategy. Any views expressed above are based on information received from a variety of sources which we believe to be reliable, but are not guaranteed as to accuracy or completeness by Sanlam Private Wealth. Any expressions of opinion are subject to change without notice. Reproduction of this commentary is not allowed in whole or in part without prior written agreement from ‘Sanlam Private Wealth. Past performance is not a reliable indicator of future results. Investing involves risk. The value of investments, and the income from them, may fall as well as rise.

Investing involves risk and the value of investments and the income from them may fall as well as rise and are not guaranteed. Investors may not get back the original amount invested.