Whither markets? Are we looking at QE 5, 6, 7, 8...?
We pondered the different messages coming from equities (generally rising) and bond yields (falling) three months ago, and concluded that bonds were more likely to be right in predicting a downturn. We have consciously shifted our ground since then - we make no apologies for doing that. For us the importance lies not so much in the Fed’s short-term shift to a neutral position, which makes a benign outcome more likely. Instead we are more focused on the longer-term message the Fed is giving: that normalisation of interest rates is going to take a great deal longer than you first thought.
In our view the key implication is that the Fed is less concerned about inflation, and more so about risks to the financial system, in particular the lack of ‘safe’ assets such as T-bills which are used as collateral across a range of wholesale transactions.
If that is the case, whither markets? We suggested a month ago that US bond yields would fall further, perhaps dramatically so, and the 10 year yield has responded by dropping 40bps in four weeks. It is still well above the 1.5% yield reached in 2016 but looks headed that way. We’d like to think that the shortage of ‘safe’ assets is behind this buying and that it is not a precursor to an economic downturn. But bonds have a strong record of predicting recessions and the yield curve is not far off flat at the time of writing. So we are wary of positing that this time it is different.
If there is a significant downturn, it seems to us almost inevitable that the Fed will turn on the printing taps again with QE4, 5, 6 or whatever it takes. That makes us more confident that 10 year US bond yields will, at least initially, carry on falling, quite possibly to new lows.
And equities? On the one hand lower or negative economic growth should depress stocks, especially as valuations are (sky) high. On the other hand, lower bond yields may force income-seeking investors to purchase blue-chip equities as they did in 2015 through 2017. Our best guess is that, in the absence of geo-political convulsions (trade wars etc), they broadly trade sideways. Any dip would be fairly quickly covered by buying but the upside is limited by low dividend growth and valuations.
Perhaps the most troubling aspect of not normalising is the distortions that cheap money brings to markets. Asset prices such as housing remain excessive, zombie companies are not put out of their misery, while the incentive for profitable companies to invest in new capital reduces because returns are competed away. The new normal may seem more comfortable than an old-fashioned recession but it is certainly not nirvana.