To paraphrase Bill Clinton’s famous election slogan, “It’s the bond market, stupid”. Rising US bond yields and steepening yield curves are dominating investor behaviour across all asset classes and negating previously unsettling moves, such as US dollar strength. After 7-years of dominance, “secular stagnation” has been ousted by “fiscal stimulus” as the dominant investment theme. The politics of populism is oft cited as the catalyst for this shift in mood with Brexit and Trump at the epicentre, but the Jackson Hole meeting of central bankers in August appears to be its primary origin, as policy makers tacitly began to admit that unconventional monetary policy had reached the zenith of its effectiveness and that something was needed. Over to the politicians to deliver on the promise of fiscal stimulus. Enjoy the moment and then look for the delivery, or not, at the end of the first quarter next year. Sometimes the journey is better than the destination… - Andrew Parry, Head of Equities
The vote for Brexit has dominated newsflow, impacted markets and led to a new UK prime minister. But in this world of weak growth, extremely low bond yields and coercive central bank policies where the most reasonable market prediction is that frequent spikes in hope and fear will continue, Andrew Parry, Head of Equities, notes that Brexit is only one of many forces contributing to ongoing volatility.
The dire predictions about the fate of global markets if the UK voted to leave the European Union (EU) remain to be fulfilled. Markets fell in the immediate aftermath of the vote for Brexit, especially sterling, but the anticipated collapse of equities has failed to materialise. The pan-European indices have declined by a mere 1% in euro terms, and, even at their worst, none of the major markets sank below their February lows. In fact, the S&P 500 hit a new all-time high. Even UK mid-caps are down only 0.7% from their pre-referendum level, despite being in the direct path of a possible UK recession amid the uncertainty caused by the momentous decision. An even more startling metric is that since the close of business on 23 June, when Britons cast their votes, the MSCI World Index has risen by over 14% in sterling terms – an all-time high. Armageddon appears to have been postponed.
Part of the reason for the relatively benign outcome is that most investors were already positioned bearishly. High cash levels, reduced equities exposure and large open put options provided strong technical support. Such pessimism was not based on politics alone – the consensus view was that the UK would vote to remain in the EU – but fears of slowing global growth. The reaction of monetary authorities, which have learned from previous crises, indicated that they would take action to support markets. The need for investors to earn a profit also contributed: with $13tn of government bonds globally providing negative yields, the hunt for attractive returns continued.
What happens now? Markets expect that central banks will act to stimulate growth and support asset prices. This is a typical Pavlovian response in which markets habitually associate uncertainty with stimulus, and exhibits their faith in the benefits of central bank intervention. The Federal Reserve’s unwillingness to immediately raise interest rates, combined with the upbeat US jobs report for June, plus a widely anticipated rate cut by the Bank of England in the coming months and expectations of more stimulus in Japan, encourage investors’ sanguine view of the world.
But central banks, as influential as they are, cannot alone dictate the course of the global economy. The full consequences of the ‘leave’ vote are unknown and were never going to be felt in the short term: the ramifications will unfold over the rest of the decade and blend in with the ebb and flow of the global economy. What we do know is that there is unlikely to be any immediate surge in growth. Uncertainty will dog markets for the foreseeable future and sentiment will suffer amid the inevitable posturing by politicians during negotiations for Britain’s exit from the EU.
Yet Brexit, as pivotal as it is, is only one of many influential risks in the global economy. From the US to China, low productivity, weak inflation expectations, excess industrial capacity and policy uncertainty continue to constrain growth. And as all eyes have focused on sterling, the Chinese authorities have weakened the renminbi as the benefits of their massive Q1 stimulus dissipate. Indeed, by destabilising world trade, a sudden and hefty devaluation of the Chinese currency would shock the global financial system more than the vote for Brexit has.
The limits of policy
Uncertainty, ultra-low bond yields and stimulus make it likely that equity markets will be range-bound for the rest of 2016. The amplitude of this range may surprise investors, as the system will be awash with liquidity. More stimulus is undoubtedly on the way, but the scale of negative interest rates in global bond markets suggests that the potency of monetary policy has been exhausted.
Fiscal stimulus could be the next policy response – it is the last one to be tried – and may further embolden investors’ risk appetite. For this to work, however, it needs to be well planned, appropriately targeted and globally co-ordinated. Such an outcome is unlikely, as there remains a deep schism on fiscal spending among governments, but it remains the hope of beleaguered investors looking for a permanent improvement in aggregate demand, rather than the short-lived sugar rush from more unconventional monetary policy.