Don’t underestimate the risks of interest rate hikes to the global economy
In recent months sentiment towards financial markets has been broadly positive in Western economies. But, as the recent UK political situation has demonstrated, sentiment can quickly change.
Such swings also happen in financial markets. Here I highlight some of the key current macro-economic issues to watch for.
Global recovery gaining traction
The world economy is recovering and looks set to grow at a solid pace this year. Sentiment has improved over the last year, although the narrative has not always changed, partly because there remains disagreement as to whether this will be sustained. Global reflation has been seen across Western economies, monetary policies are still accommodative, despite Fed tightening, and fiscal policies have been relaxed.
Nominal GDP (growth plus inflation) is higher and – provided policy rates and market yields do not rise significantly – this will help debt dynamics, allowing budget deficits to fall. Asset prices (equities and bonds) have remained well-underpinned, despite the recent dampening effect on equities of the weak oil price.
But there are still widely diverging views about what happens next. Markets assume more of the same, with inflation and rates relatively low, growth steady. Beyond that, views range from stagflation (slower growth, plus inflation), to a weak growth outlook with slower US growth and low inflation, to more positive views. My view is that global growth should be solid over next year, but the US economy lacks momentum and the UK is slowing.
Western monetary policy will normalise
If the recent pick-up in global activity is sustained, what we need to prepare for over the next six months is that markets will focus more on a normalisation of monetary policies. Whether it happens remains to be seen. Exit strategies will vary, with the US leading, the UK next, while the European Central Bank (ECB) and the Bank of Japan (BOJ) will lag. It will in turn have currency implications.
In recent years major central banks’ monetary policy has diverged. The size of the balance sheets of the ECB, BOJ and Fed are all now similar – around $4.5 trillion – but as a proportion of their economy, very significantly, being considerable for Japan. While the Fed’s balance sheet has been broadly unchanged for three years, both the BOJ’s and ECB’s have risen sharply over the last year. The BOJ’s actions have underpinned Japanese assets, while the ECB’S behaviour has played an important part in the current euro zone cyclical recovery.
Given the impact of low rates, we should not underestimate the risks associated with a rise. Monetary policy has successfully minimised downside economic risks, but the prolonged period of both low and predictably low rates has had multiple side effects. Markets have not priced properly for risk and it has fed asset price inflation. Low rates have lowered the price of leverage and contributed to increased debt.
Resources have been mis-allocated, as zombie companies have been kept alive and finance directed towards financial assets rather than real investment. Following the crisis – particularly in the EU – there was talk of the need for reform, but monetary policy may have delayed that. Also, it has provided a stable backdrop for changes to be pushed through in the banking sector.
There have been spill-overs from country to country, including more international buying of Government debt. Markets and economies may be vulnerable to this stimulus halting or reversing. There is no definite rule as to what this means. But it implies a phased withdrawal of quantitative easing (QE) and higher rates – implying a rise to levels more consistent with low inflation and for many central banks, including the Bank of England, consistent with a 2% inflation target.
The Bank of England’s policy rate is at its all-time low of 0.25%, its Government bond purchases are £435bn and corporate bond purchases £10bn. After the recent 5-3 vote to keep policy unchanged the Bank is closer to a rate hike, although one is not necessarily imminent. One member who voted for a hike has been replaced by a new member after her term finished and, while the Bank's chief economist gave a mildly hawkish speech on rates, the governor has sought to play down talk of an early hike.
Emerging economies are performing strongly
Another consequence of global recovery is the strong emerging markets performance. While there are many different measures, the IMF's annual growth rate is a good guide.
Growth peaked in 2010 and slowed until last year and may be in the early stages of a pick-up. Early last year the fear was of a China slowdown – now the sense is its economy is recovering. India, too, is growing steadily. This has contributed to more positive sentiment towards emerging markets.
China’s Belt Road: growth but future volatility
China's Belt Road initiative includes large-scale infrastructure spending, energy investment in markets along the route and other tie-ups across the globe. Quantifying the full impact is still difficult but essentially it is China going global. Three years in and, despite initial scepticism – even in China – it is the President’s pet project and so is gaining greater traction: witness the recent Beijing summit attended by 29 world leaders, despite a US-led boycott.
Indirectly it plays to emerging economies, and even global firms in the UK and elsewhere that can leverage off this. China’s near-term challenge is increased international awareness of its poor debt position, linked to its shadow banking sector and domestic credit growth. As the IMF highlighted at its spring meeting, the Chinese debt situation warrants attention. For now, steady growth suggests this is a future worry rather than a current problem. For the Chinese economy, the trend is still up but there will be setbacks.
UK risks have increased
The biggest challenge for investors is UK politics. There are multiple issues; a negative impact on economic activity, which may already be happening, judging from the recent Institute of Directors (IoD) survey, although witness the knee jerk reaction after last year's referendum; political risk – an early election is still possible but it is most likely the Conservative Government struggles on, perhaps with a new Prime Minister; and international attitudes towards UK assets – again this may not change too much, but international investors hold around one half of UK equities, one quarter of the UK commercial real estate market, over one quarter of gilts and around one half of UK equities.
EU exit negotiations have started, with the focus on EU citizens’ rights, the divorce settlement and Northern Ireland. Beyond that, markets may be sensitive to any perceived disagreement between the Chancellor and Prime Minister. Add in the diverging views at the Bank of England mentioned earlier and it points to a potentially more volatile time for UK assets.
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