How are central banks expected to act for the remainder of the year?

02 August 2018

How central banks are expected to respond to ongoing economic developments.

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What you’ll learn:

  • What the latest economic developments are.
  • How the world’s major central banks are expected to respond to these developments.
  • How central bank actions will affect markets and investors.

Last week we explored the effect of the fractious political environment on markets. This week, after a rash of central bank meetings and action, we explore the role of central bankers as we look to the end of the year. Having occupied centre stage for much of this economic cycle, the world’s central bankers have returned to their more normal supporting role for much of the last six months. Action has more or less matched expectations and there has been little cause for anything more dramatic, as US economic vitality has spread to the rest of the world. As we look over the next 12 – 18 months, we still think there remains the potential for a more hostile interest rate environment around the world.

Bank of England

On Thursday, the Bank of England raised the base rate for the second time in this cycle. This move is not part of a smooth and persistent normalisation so far witnessed in the US. The UK’s central bankers are engaged in a more protracted and stuttering reload of their monetary arsenal. The UK economy continues to make heavy weather of the favourable global backdrop. Self-inflicted uncertainty continues to deter investment and real wage gains remain substantially absent in spite of a fully employed workforce. In the short run, we should expect more of the same, particularly while the nature of the economy’s exit from the EU remains hazy.

Further out, the pull of a relatively attractive demographic profile, a still robust institutional context, and a competitive corporate sector should reassert itself on the growth rate of the economy. However, until then the UK economy does not look set to provide much scope for anything other than a drawn out and tentative rate rising cycle. For investors, the reminder is again that capital markets, even those domiciled in the UK, are just not that interested in the fate of the UK economy. Sterling’s spasms can certainly have an effect on portfolio returns from currency translations, but for the intrinsic worth of stocks and bonds, it’s the US economy that matters most.

Federal Reserve

The booming US economy and its capital markets should continue to set the drumbeat for returns elsewhere. It’s no exaggeration to say that the US Federal Reserve effectively set the stage for how other central banks around the world conduct their monetary policy. For the moment, the process of delicately untangling the economy from a decade of experimentation (quantitative easing) has proceeded without major hiccup. The wails of doomsayers who have regularly insisted over the last several years that the world’s economy and its asset markets are little more than a central bank inflated bubble, look increasingly hollow.

This operation has been facilitated by a mostly benign economic setting; growth has remained strong, jobs continue to be generated, but inflationary pressure has remained substantially absent. That pressure is gathering a little on the evidence of this week’s employment cost data, but still not to the extent that would panic central bankers or bond bulls.

Nonetheless, as we’ve pointed out before, theory would argue that adding tariffs to imports and dumping a load of spending and tax cuts on an economy already operating at or around full employment should see aggregate prices rise in an economy. That we haven’t so far, does not mean that we won’t. The overwhelming majority of the recently imposed $34bn of tariffs was applied to intermediate goods, i.e. the components of production – where price rises may take a little while to spread to wider inflation. As more of China’s imports are hit with tariffs, the proportion of final consumer goods affected will rise with it, as will the speed with which tariffs translate into higher consumer prices.

As ever, lashings of humility are appropriate here. The forces that drive inflation remain poorly understood by textbooks, academics and practitioners alike. A bond market running scared from a more vivid inflation threat is one of the key risks to our benign outlook for the world economy. Admittedly, it looks better equipped to deal with this upside inflationary risk compared to 6 or even 12 months ago. Still, low to negative prospective real returns from the asset class leads us to favour stocks over bonds, especially given our view that a recession isn’t imminent. However, right now, incoming data continue to be a source of comfort.

Investment conclusion

Little flickers of action from the central banks of the UK and Japan, combined with a pass from the US Federal Reserve, may have given some the impression that the natural order of the last few years is starting to fracture – the rest of the world is finally joining the US in weaning their economies off the extreme monetary medicine of the post crisis era. This would be a misconception. The Bank of Japan seems to be simply bedding in for an even longer period of easy monetary policy than previously planned. Meanwhile, the Bank of England is probably now done until deep into next year. The market is probably rightly not expecting much out of the European Central Bank for at least 12 months, after firm guidance from President Draghi.

We have recently slightly reorganised our fixed income exposure within our own Tactical Asset Allocation (TAA)1, by shifting our exposure from riskier corporate debt to safer, shorter-term government debt. The overall character of our TAA remains one that will benefit from continuing economic growth, thanks to its tilts towards developed and emerging market equities. However, this move does fractionally increase the resilience of the TAA in the event of a less sunny outcome.

These are our current opinions but the future, as ever, is uncertain and past performance of investments is not a reliable indicator of future performance.

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