THE financial markets continue to behave in a complacent and perverse manner.
The equity markets have recovered from their August setback, in spite of evidence that that the world economy is slowing and prospects are worsening. The downgrading by the OECD of its global growth forecasts is the latest confirmation of this pattern. The fact that potential disasters in China and Greece were avoided, while the US Federal Reserve postponed its long awaited tightening, can explain only partially the remarkable resilience of share prices and their ability to bounce back so far from recurring setbacks.
On most accepted measures – e.g. P/E ratios or dividend yields – most equity markets are in overbought territory. Bonds are behaving even more oddly, particularly in the eurozone, where two-year government bonds have been negative for some time. Paying governments for the privilege to lend them your money is strange, to say the least, particularly when one of the borrowers is a heavily indebted country such as Italy, which can hardly be described as risk-free. It is also difficult to justify persistent minimal inflation and low inflationary expectations, in view of the huge monetary expansion seen in recent years.
We will not know for some time if these are temporary and relatively harmless distortions, or whether they risk creating dangerous bubbles that will cause economic damage in the future, when the excessive stimulus now in place is eventually withdrawn. In the equity markets good news is treated as bad news. Signs of strength in the real economy tend to cause setbacks, as markets become concerned that central banks would be under pressure to tighten policy. Conversely, disappointing figures trigger rallies, as traders become hopeful that interest rates will be kept at ultra-low levels for longer, and central banks may inject more liquidity into the economy through additional doses of QE. This response is illogical and unsustainable. Weaker growth means lower profits and cannot be good for share prices in the long term. It is clear that markets are too dependent on abnormally low interest rates and on injections of cheap money. Both the US and eurozone economies provides stark examples of irrational market reactions.
December rate rise
US GDP growth slowed in the third quarter of 2015 to an annualised rate of 1.5%, down sharply from an annualised rate of 3.9%t in the second quarter of 2015. Although our full year US GDP forecast for 2015 is downgraded to 2.4%, the markets welcomed the drop in Q3 growth, in the hope that the Fed may be persuaded to wait until 2016, before starting to raise rates. But chairman Janet Yellen’s warning that a December rate rise remains a realistic option shifted the market’s mood in a hawkish direction, and the much stronger-than- expected October job figures reinforced this expectation.
The US economy created 271,000 new jobs in October, almost 100,000 more than most analysts had expected. The unemployment rate fell to a 7-1/2-year low of 5%, while annual wages growth, which has been almost stagnant until recently, rose to 2.5%, the biggest increase since July 2009. The initial reaction was swift: equity prices fell, bond yields plummeted and the dollar rose strongly. The markets rightly concluded that surging employment and rising wages will persuade the Fed that an early rise in official interest rates is justified. Though not yet a foregone conclusion, a December increase now appears increasingly likely. Only exceptionally adverse economic news in the next few weeks will persuade the Fed to wait longer.
Eurozone economic growth remains humdrum, but the modest improvement seen in recent months is consolidating. Full-year growth, forecast at 1.5% in 2015 and 1.6% in 2016, will remain weaker than in the US and the UK, but will still be stronger than in the previous three years. The mood of the eurozone financial markets has become less gloomy, as the crisis facing Greece has become less acute and the violence in Ukraine has eased, at least temporarily. But the region is facing new problems, the most serious being escalating economic and political tensions caused by the influx of refugees and migrants from the Middle East.
Though the unemployment rate fell to a three-year low of 10.8%, this is still much too high. With eurozone annual inflation stuck around zero, the European Central Bank appears determined to inject further monetary stimulus as early as December, to counter the risks of a slide into Japanese-style stagnation. While the main policy rate will probably stay at its ultra low level of 0.05%, it is expected that the ECB would move its deposit rate, which was cut to -0.2% in September 2014, further into negative territory. This would discourage savings and encourage spending and lending. But since negative deposit rates are effectively a tax on bank profits, the ECB will cut rates only very modestly. If additional measures are deemed necessary, the ECB will increase its current QE (asset purchase) program above €60bn per month, as well as extending it beyond September 2016.
Divergent policy steps
The growing likelihood that both the Fed and the ECB would decide to adopt divergent policy steps in December, almost simultaneously, is most unusual and potentially destabilising – most particularly for the bond and currency markets. The policy-sensitive two-year yield gap between US Treasuries and German Bunds is already at a record high, and the euro has fallen markedly against the US dollar.
The US Fed is now the only major central bank that is considering tightening policy in the near future. All the other key players are planning to inject further stimulus. The policy divergence has intensified in recent weeks, as the UK signalled a major shift. The tone of the Bank of England recent Inflation Report was unexpectedly dovish, and indicated that monetary tightening will occur later than previously expected. The markets now believe that the first increase in UK official interest rates will take place in the third quarter of 2016 at the earliest.
Indeed, there is a reasonable prospect that a rise in UK rates will be delayed until the early months of 2017. The policy gap between the US and other major central banks intensified further following the decision by the People’s Bank of China to cut its key one-year lending rate from 4.6% to 4.35%, in reaction to evidence that the Chinese economy is slowing and inflation is falling. Further cuts in Chinese rates can be expected in the coming months. In Japan, the central bank left policy unchanged at its recent meeting. But with growth and inflation remaining persistently weak, further stimulus can be expected, and the Bank of Japan is likely to increase further its QE programme.
As these conflicting policy moves take effect, investors should expect recurring upheavals and volatility in most markets in the next few months.
David Kern of Kern Consulting is Chief Economist at the British Chambers of Commerce. He was formerly NatWest Group Chief Economist.