Investment Management –
Our Co-CIO, Gregory Perdon shares insights from across the globe, key market developments and recent Investment Committee decisions.
Why do comments out of the Federal Reserve always dominate financial headlines? Because Fed officials control the monetary policy of the world’s largest economy and the decisions they make impact foreign exchange, interest rates, lending growth and financial conditions. It’s for those reasons the markets hang off every comment made or set of minutes published. So, what is the bottom line?
When will the Fed end monetary support?
The Fed is divided about when to start reducing the significant monetary policy support which has been on offer to markets (a combination of ultra-low interest rates, dovish forward guidance and bond buying, otherwise known as QE). Why would they feel compelled to reign it in? Because inflation is beginning to manifest itself and asset prices have rallied significantly - both of which can potentially pose risks to financial stability.
The Fed now finds itself in a conundrum - if they reduce the support too soon, they risk a "taper tantrum" (a spike in interest rates) which could choke the recovery, but if they wait too long, and excess leverage gets added back into the system, they risk an almighty sell-off which could threaten employment (generally when stock markets do very poorly, unemployment goes up). The art (not science) of managing monetary policy will be about finding that balance which – arguably – will be one of the most difficult jobs in the world. Our take? Very broadly speaking, the Fed has four levers they can adjust. The committee can raise rates, decrease the amount of government bonds bought, reduce the quantum of mortgages they purchase, or talk down the market.
Ways the Fed can begin withdrawing support
We think their first step will be to slow their mortgage bond buying since the US housing market is literally red hot. According to the S&P CoreLogic Case-Shiller National Home Price Index, home prices reported a 14.6% annual gain (as at end of April 2021). |There are many factors which have contributed to this rise (such as significant fiscal support) but it would be difficult to make the case that mortgage purchases have not contributed. When the Fed buys mortgages (as part of their quantitative easing programmes), they in essence push mortgage rates down (which can be viewed as a subsidy). For more information, I refer you to my recent op-ed which was published in City A.M. Our view is that reducing mortgage purchases is the least disruptive of the four levers and it will be the first one to pull, the question then becomes when and by how much.
Strong growth in US service sector
In other economic news, activity in the US service sector continued to grow at a strong pace in June, the ISM Services Report on Business PMI registered 60.1 (but down from the 64.0 record high in May). The reopening of sectors such as hospitality, leisure and travel is fuelling a consumer-spending boom - to the point that some firms are communicating that they cannot keep up with the steady demand and are struggling with labour shortages. One could make the case that it is a good problem to have but it might introduce the next big hot potato: wage inflation…
Although the vaccination roll-out has been a strong catalyst for a rebound in economic activity, along with an increase in confidence, the recovery moderated in May as growth slowed in retail, construction and manufacturing (offsetting a significant rebound in hospitality and leisure). Quarter-on-quarter growth in the three months to May was 3.6% (but economic output was still 3.1% below pre-pandemic levels).
Job creation was the fastest in seven years, but like the US, staff shortages are contributing to backlogs and this is helping push prices up. Another trend which is creating a challenge is the global chip shortage which is disrupting manufacturing and sending car and truck production downwards. Finally, strong gains in the UK housing market have been registered over the past 12 months, with property prices up circa 8.8% having benefitted from reductions in stamp duty. Will transaction volumes begin to decline? Potentially.
Similar themes are dominating news from the continent. IHS Markit's final composite PMI rose to 59.5 last month from May's 57.1. This was the highest reading since June 2006, which is brilliant news for the recovery, but with it comes some of the same problems facing the UK & US, namely an uptick in inflation, labour shortages and disruptions to supply chains. Our take? Some inflation and disruptions should be expected during a recovery, in fact we have been complaining about a lack of inflation for years in Europe, so finally we are getting what we have been seeking against a positive back drop and for the ‘right’ reasons. The question then becomes what does the European Central Bank do about it?
And on that exact question, just last week the ECB decided to revise its inflation target and allow consumer prices (inflation) to ‘overshoot’ the 2% target when required. No surprise there! Speaking at a press conference on Thursday, ECB President Christine Lagarde said the new inflation target is “clear and easy to communicate.” The follow-on question is: if it overshoots, when will they adjust their bond purchase programmes (QE)? We will be watching…
More fiscal bazookas are being unveiled in Japan by PM Suga. What is the number? The next economic stimulus package is expected to be worth at least $180bn according to a Bloomberg survey. Could the catalyst be part of an attempt to regain popularity? Perhaps, but equity markets will definitely like it, regardless.
Last year, we were all buying extra webcams and board games as we all adjusted to working and schooling from home. Now that we all have the “goods”, don’t we all want some more “services” (like domestic holidays)? Of course we do, which is why Chinese officials are perhaps a bit worried about a potential moderation of exports – so naturally, they are making adjustments. For example, the central bank (PBoC) is cutting the amount of cash that banks must hold as reserves, releasing an estimated 1trn Yuan ($154.19 billion) in long-term liquidity (effective 15 July). Also contributing to the worry is the recent surge in raw material prices (which can make exports more expensive), but is that quantifiable? It certainly is, as the National Bureau of Statistics (NBS) recently reported that the producer price index (PPI) increased 8.8% from a year earlier. That said, Chinese economic data has been strong of late, and we see that serving as a general tailwind for global growth for the rest of the year.
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