THREE months ago, I argued against the temptation to sell in May and that this year’s equity rally could continue as the global economy improved and as virtually free money remained in bountiful supply.
Thankfully, this proved correct, although nearly three-quarters of the 6.4 per cent return from global equities since the end of April arrived courtesy of a sharp fall in the pound, for which we have our politicians to thank.
While economic conditions have improved in parts of the world such as Japan and the US, in others, including the UK and China, economists missed a sharp weakening in activity. Any growth disappointment has been more than offset by the warm glow of a much easier monetary policy outlook.
Within the major central banks, conviction that the world remains gripped by powerful disinflationary forces has strengthened. US Federal Reserve chairman Jerome Powell recently highlighted influences including demographic trends, globalisation, weak productivity growth, demand for safe assets, and weaker links between unemployment as fostering low, and falling, inflation. These factors are likely to persist.
Against this backdrop, and recognising that the tightening of global monetary conditions last year went too far, European Central Bank (ECB) president Mario Draghi and then Mr Powell at the Fed reacted by unexpectedly signalling policy easing.
Prior to last September, US bond yields had been rising steadily, driven by moves to normalise (raise) US interest rates, but these yields turned down as soon as US cash yields went above the prevailing inflation rate. The inference is clear: even as it was being buoyed by substantial tax cuts, the world’s strongest economy couldn’t cope with a positive real interest rate.
Recent surveys suggest that the next global recession will hit within the next 18 months. This explains why investors have retained a defensive posture and, for the most part, have not participated fully in the market gains seen this year.
It seems reasonable to suppose that if this happens, the zero (or negative) long-term government bond yields of Europe and Japan will become the norm rather than the aberrant exception. Such a move would imply that ten-year US bonds, even yielding just 2.1%, offer exceptional value.
Thereafter, the stark implication for investors is clear: more than a decade after the onset of the Great Recession, no one will be able to earn a secure positive return without embracing market risk. The talk of the steamie last year, normalisation is again a forlorn hope.
Former Federal Reserve chairman Ben Bernanke’s programme to avoid deflation, which was offered sagely in 2002, became central bank policy after the Great Financial Crisis. Policymakers stopped short of the nuclear option of deliberate currency debasement, recognising the demons that this would unleash.
The latest disruptive act from President Trump has been to promote intervention in his own currency. Ironically, the US dollar has been strong partly because of Trump actions. The restart of ECB quantitative easing could prove the catalyst for official dollar selling, launching tit-for-tat, beggar-they-neighbour reactions.
While this sounds a poor backdrop for investors, monetary policy will, even more aggressively than before, deter anyone from holding cash.
The monetary explosion likely ahead of an imminent recession will see equity markets move higher, challenging investors. While markets move higher, momentum strategies should continue to outperform.
The outlook, then, is for more of the same. Storm clouds will gather and policy will lean against slowdown.
When Mr Bernanke unveiled his plan to defeat inflation he entitled his speech Making Sure ‘It’ Doesn’t Happen Here. These days the ‘it’ is recession.
We have learned to live with near-zero inflation. No one is sure how we will cope with near-zero growth.
Stephen Jones is chief investment officer at Kames Capital.
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