“Central banks abandoned their 2018 tightening bias faster than investors expected. Recent global data and the inversion in the US yield curve comfortably justify this move, while setting up a tricky environment for risk assets.” – Dario Perkins of TS Lombard in Deflation Returns, Macro Picture, March 28, 2019
Global markets are currently characterised by increasing underlying uncertainty. The generally positive outlook at the beginning of 2018 unravelled as volatility increased. The year ended in disappointment for investors as many asset classes delivered low returns. In light of these developments, major central banks – especially the US Federal Reserve – took stock and reviewed policy actions. Quantitative tightening (QT), or normalisation of the previous unprecedented easy monetary policies, made way for a pause.
The market sell-off towards the latter part of 2018 made authorities realise that continued QT posed risks to financial markets and potentially the economy. This would appear to underline the fact that markets, and thus the economy, are tenuous and very much dependent on stimulus or easy policy measures; in other words, markets and economies have become addicted to quantitative easing (QE), so that any normalisation of policy measures is fraught with potential risk.
Easy money, with its consequent low cost of capital, seems to have become essential to maintaining stability and sanguine underlying sentiment and confidence, while at the least containing financial market nervousness. Central banks realise that they have limited firepower in their arsenal to intervene and support markets in the event that they break down, with a likely knock-on effect insofar as it would drag the economy along in its maelstrom– so relaxing QT has become vital to stabilisation.
A number of respected market pundits see this as continuing to kick the can down the road. The debates and opinions are quite divergent, but it is clear that there is a general need for supportive policy action and the right macro noises to sustain markets.
Ongoing interventions, stimulus
Markets are highly sensitive to macro policy developments and have been dependent on ongoing interventions and stimulus since the global financial crisis (GFC) of 2008. Market volatility over the last while has revealed the underlying market weakness and shown that failure to act supportively and timeously risks a relapse of the seemingly fragile progress made since the GFC.
Indeed, this revelation was reinforced by one of the most significant market recoveries or rallies ever recorded at the beginning of this year. Bullish sentiment was reignited by a change in policy direction, notably the QT pause by the Fed as well as a relaxation of policy actions elsewhere. Contributing to the rally was stimulus by China and promising signs that the US and China would achieve some agreement on trade.
Yield curve inversion will reinforce the dovish stance adopted by central banks as the authorities will have to continue with measures necessary to keep markets calm, if not positive. The big question is for how long, and at what point is a more virtuous cycle or self-sustainable economic condition reached such that the monetary authorities can affect normalisation of policy without the market going into trauma? The jury is still out.
Unprecedented and crisis-driven policy measures, necessary to turn the tide of the GFC, have become vital even after more than 10 years since the crisis. The reality is that these measures or interventions have clearly disrupted and repressed the normal pricing mechanism of the market.
QE, or monetary stimulus, has triggered a significant rise in asset prices rather than the anticipated inflationary pressures in the economy. This attests to the fact that what we have are indeed unusual market and economic conditions. There is much risk in viewing and treating this cycle as normal or typical. Markets and economies have not been allowed to ‘cleanse’ themselves normally as per previous cycles. Rather, the aim of QE was to stave off the potential for deeper negative economic developments given the severity of the financial crisis at the time. The risk of deflation and its ramifications was something central banks needed to avoid at all costs and, as some have put it, they had to “do whatever it takes”.
Considering this, prudency would require vigilance to the potential for major disruption in an environment where markets have become significantly dependent upon, if not controlled by, central bank policy. At some point, the can cannot be kicked any further.
Fabian de Beer is director of Investments at Mergence Investment Managers.