The importance of the Fed's change of heart in January

Last autumn we were confidently predicting that US 10-year yields would go above 3% and, for a short while, they did.  Today they are at 2.5% and we are equally confident they are going lower.  What has changed? The short answer is the facts.  The US Federal Reserve’s change of heart in January was in our view much more than a simple move from a tightening pathway to a more neutral position.  We think it was an admission that QE is here to stay for the long-term and that interest rates are in today’s world not able to perform their traditional function as a policy tool.  If so, that means investors have to think radically differently going forwards. Perhaps, we should first ask why?  Our friends at CrossBorder Capital think the catalyst is the frailty of corporate bond markets and particularly at the bottom end of the investment grade credits – BBB.  Institutions and corporates have been looking for safer, and perhaps higher, returns for their cash than they can receive from banks.  One response has been to invest in money market-like funds, which in turn lend to different corporates via repurchase agreements (“repos”) in order to minimise risk.  However, these repos depend on the availability of collateral in the form of ‘safe’ assets such as short-term government bonds.   Quantitative tightening means the latter are in scarce supply, accentuated by demand from some central banks (eg. Bank of Japan) for their own QE programmes.  CrossBorder’s data suggests that the average net supply of ‘safe’ assets’ over the last six years has been roughly one third of the 2010-2012 period and it is increasingly concentrated in the United States. The implications are numerous.  In the bigger picture, the Fed will use its balance sheet rather than interest rates to steer the economy.  We call that QE4.  While it may not inflate asset prices in the way that QE1, 2 and 3 did, it does provide the equivalent of a Greenspan ‘put’ for investors.  The US bond curve is likely to fall, possibly in an extreme case to levels similar to Japan, though in practice we doubt that.  In turn that may propel equity valuations higher as investors seek return. Inflation is a tougher question.  The history of QEs 1, 2 and 3 was that consumer inflation did not take off.  Today the employment background is tighter and society is less cohesive.  Governments may decide that inflation is the lesser of various evils and be prepared to accommodate some.  Far be it from us to suggest that that would also help them inflate their indebtedness away. If we are wrong, the brunt is likely to be borne by those lower down the debt hierarchy – BBB grade, non-investment grade debt and equity holders.  It’s no secret that not all BBB rated credit is worthy of its rating but if collateral for repos becomes scarce or unavailable even companies with unimpaired credit could find themselves struggling to refinance their existing corporate debt.  That could trigger a much sharper funding crisis as (shades of 2008 GFC) rating agencies find themselves re-evaluating their ratings. We see the path of the next few months as critical.  It all depends on whether the central banks are watching the right balls.  If you’d like to discuss this in further depth, please give us a call on +44 20 3637 6341. 

Times they are a'changing

We’ve spent most of the last two years or so marking how tight the monetary environment is.  It is not just that the US Federal Reserve and to a lesser extent other central banks have until very recently been withdrawing liquidity, it is also how the private sector has been less willing, or able, to use or extend credit.  That has been behind our bearish stance on the market and also western economies. But times they are a’changing and, in Bob Dylan’s words, ‘the slow one now will later be fast’.  Most obviously, the Federal Reserve has changed course from its path of steady tightening to a more neutral position.  That can now be seen in the end February and early March data.  More discreetly, the ECB and Bank of England have become more accommodative while the PBOC, until now the loosest central bank, is tightening.  The reasons are not hard to seek: the US economy was previously, as we have said, heading for recession while Europe is drifting in the same direction.  We’d argue, as we did in our last blog, that Abenomics needs a reboot and we can expect significant policy action from Japan too. Though equity markets have risen in reaction, we’re not sure this can be maintained.  Valuations, at least in the US, remain extremely high by historic standards.  That doesn’t mean they will necessarily revert to the mean in the short term: that may have to wait until bond yields normalise.  However, equity investors are unlikely to get more than the yield (3% globally, a juicy 5% if dividends aren’t cut on FTSE 100) +1% or so growth.  There simply isn’t room for valuation expansion and there is significant room for valuation contractions if things go wrong. So times they are a’changing but our views on equities remain biased to the negative.  In the short term we prefer investments which are priced off bond yield curves.  In other words, we remain risk off.​

Does Abenomics need a reboot?

My favourite commentator on Japan, Peter Tasker, has written a blog asking whether it’s all about to go wrong for Japan.  His evidence is an interview on Reuters by the guru of Koichi Hamada suggesting that ‘the public is better off having prices fall, not rise…’ and that now is time for the next consumption tax rate rise.  If you don’t follow Japan, all you need to know about that is that previous ones have proven highly contentious. Hamada may just be accepting reality.  Nominal GDP growth in Japan has been negative again over the past two quarters and the country is also flirting with deflation anew.  As the employment participation rate (16-64 year olds) stands at 77%, his comments are consistent with what’s happening – if you are in employment, deflation is beneficial. The bigger point Peter makes is that Abenomics needs a reboot.  After six years the effects are fading, along with QE round the world.  Peter’s recipe is to cancel the consumption tax rise, to target bond issuance rather than the yield curve, and to wait patiently for tight employment to have its effect on inflation.  I’d add to that the boost that the Rugby 2019 World Cup and 2020 Olympics will give Japan.  And the stockmarket?  I’ve been lukewarm for the past 12 months and remain that way.  There’s scope for upside if some of Peter’s suggestions are followed.  And in the long-term there’s still plenty of good news on corporate governance, despite the Nissan/Ghosn furore.  However, I suspect some patience is required.  At home, corporations are still saving rather than spending, and abroad economies are slowing and the yen looks like strengthening.  Plus, of course, if the Bank of Japan were to target bond issuance, it might sell some of the equities it has purchased over the past nearly five years. ​

The US Federal Reserve has changed its tune. Should we do the same?

At the end of January the Federal Reserve signalled that it will, at the least, be less aggressive in raising rates.  It cited inflation stable at close to its target 2% rate and greater uncertainty in global growth.  The comments didn’t rule out further rate raises but the Fed currently looks to be in neutral gear.    This was of course music to our ears, as we have been saying for almost a year that the Federal policy was too tight and would inevitably result in a recession.  But the half of the market that doesn’t read the Linchpin blog viewed it as a U-turn.  On our thinking it may still be too late to avert an economic downturn but, if this does prove to be the peak of US rates in this cycle, then the Fed. has at the last moment got it right. The consequence is that we have become a little more positive about risk assets such as equities.   We still expect one more down leg in markets but the probability now is 75% rather than 95%.  Should we change our tune and suggest to investors that it is time to buy? The straight answer is not yet.  For one, the Fed may yet raise rates, and secondly there is always a lag between the turning point in the liquidity cycle – currently rock bottom in the US on the data we look at - and moves in the market.  But we have, for the first time in three years, extracted our buying boots from the cupboard and if markets were to fall back to end-December levels we might even be tempted.​

1916 or 1936?

I am reading Andrew Roberts’ biography of Churchill.  I wish it had been published in two volumes rather than one to save my arms but it is very good notwithstanding.  I can’t help noting similarities with today’s politics at two points in time in particular. In 1916, following the disasters of the Somme and Gallipoli, and constitutional arguments over Ireland’s independence and universal suffrage, the Liberal party led by Asquith split.  David Lloyd George, also a Liberal, became Prime Minister of a Coalition Government comprising Conservatives and Liberals, and proceeded eventually to conduct the war successfully and win a huge majority at the khaki election of 1918.  It was, incidentally, the first election in the UK held on a single day.  Of course we now know that since splitting the Liberal Party has never regained power in its own right.   In 1936, the threat from Germany was clear, and the main argument was whether or not to re-arm, with India’s independence a second flashpoint.  The issues were again seminal, the parliamentary debate short of thoughtfulness, the opposition, at least on the question of rearming, limited to Churchill and one or two others, the Prime Minister accused of putting party ahead of country, and voters fed up.  There had just been an election in 1935 and in practice the National Government stumbled on until the crisis of 1940, and eventually the election of 1946, where the electorate roundly rejected it. Today we have an ineffably weak leadership, ineffective opposition, a rancorous debate and a similarly unhappy electorate.  Are the parallels with 1916 greater than those of 1936?  I would certainly prefer to see a political realignment where one or both major parties split to more years of wrangling followed by a more existential crisis.  Even if it means the Conservative party is out of power for 100 years.


We appreciate that it’s a rear-mirror view but end December data from our friends at CrossBorder shows unequivocally that investors have moved to being risk-off.  Their World Risk Exposure* index moved from approximately neutral to -37 (‘normal’ range -50 to +50), or approximately two standard deviations below trend.  We would suggest that a capitulation of this scale is a necessary pre-condition to a new bull market but we don’t believe that it is yet sufficiently sustained to send a buy signal.  Long experience tells us that bear markets rarely end in a single sell-off, though there are exceptions such as 1987. Our reasoning is primarily that funding liquidity globally remains at a level (16 on a range of 0 to 100) which is predicting recession.  No surprises that the US Federal Reserve is the biggest drag but it is worrying that the People’s Bank of China, until now the least tight major central bank, has shown signs of tightening.  It may only be a temporary phenomenon ahead of the Chinese New Year, but given that central banks are in our view far too tight in their policy already, it is not helpful.  The ECB, perhaps with the possibility of a no-deal BREXIT in its head, is now the loosest major central bank. We continue to think an economic downturn is almost inevitable and a global recession likely.   However, for investors trying to time when to dial up their risk exposure again, the first shoe is now dropping.  The second shoe will be an upturn in funding liquidity.  We’d expect that to happen in the second half of 2019. *Risk Exposure data measure the % of the global portfolio held in risk assets as against ‘safe’ assets such as cash and bonds.   

Too early to put the pedal to the metal in Japan?

We’ve had our feet off the pedal on Japan for much of 2018, as regular readers will know.  It’s not that things were going wrong with the economy, more that stockmarket investors - or was it really buying by the authorities for political rather than investment reasons – had gotten ahead of themselves. We pointed out in 2018 that there was a structural change for the better in profit margins and that the very low level of leverage meant that could be boosted significantly by borrowing.  We also pointed out that Japanese valuation disparity was relatively greater than other major markets, indicating an inefficient market.  Add in Prime Minister Abe’s seemingly secure tenure and relatively looser monetary policy in both Japan and China, and the combination should have made a profitable hunting-ground for active investors. It didn’t turn out that way and we now have the added weight of the Nissan saga - casting doubts on corporate governance improvements in Japan - as well as a sharp increase in the yen.  We are not surprised that on Christmas Eve the Nikkei index fell to a bear market territory reading of more than 20% below its 2018 high. We are still refraining from treading hard on the metal but our reasons are more macro than micro.  Our biggest concern is that investors will use the yen as a safe haven if global markets take another leg down.  Currency volatility has been suppressed over the past few years and investors are probably underestimating the risks. The positive story on Japanese earnings is still very much in place, notwithstanding the gloss may have come off governance.  Active investors will probably enjoy good profits from Japan over the next couple of years but our hunch is that there will be a better entry point coming up quite soon. To find out more about our specialism in Japan please click here.​

​Linchpin 2019 Inflation Update

William Bourne has since 2012 written an annual update on the long-term outlook for inflation by monitoring shifts in a varied range of inflation indicators.  Last year for the first time the consensus tipped towards inflation: we agreed on the direction of travel but argued significant rises were not yet imminent.  One year on, austerity has clearly been abandoned, and protectionism is on the march: we consider both to be inflationary.  On the other hand, the US Federal Reserve’s determination to cap inflation will in our view lead to an economic slowdown, which is deflationary. A year ago we concluded that deflationary forces had after 25 years finally been outweighed by more inflationary ones.  Behind this lay secular indebtedness, shifts in relative power between capital and labour in the West, and a cyclical upswing in Emerging Markets economies.  We argued that higher inflation is inevitable eventually but placed more emphasis on market indicators suggesting not quite yet. Headline numbers in 2018 have continued to rise gently to around 2% in most of the world.  Japan is an outlier below this number and the US an outlier above. The final abandonment of fiscal austerity by most developed countries is clearly inflationary in the long term.  Not only does it build up government debt level, but by adding to demand it increases pressures in areas such as labour costs.  It confirms our view that western money will ultimately be debased.   Under the traditional model, new demand would be filled first from spare capacity.  Today the output gap is minimal in most countries, and the new demand is often in different industries and areas to where excess supply lies.  We have not changed the indicator for the output gap, but we have for deleveraging - really it is now a case of leveraging. In 2017 commodity prices rose by 8% and we marked them as Inflationary.  In 2018 non-energy prices were not greatly changed but oil prices rose by around 25%, so we have maintained this measure as Inflationary.The growth in trade friction is another factor leaning towards inflation, both prima facie as tariffs are added to goods but also in the longer term as competitive pricing pressures reduce.  We have moved the Costs indicator (re-named from Labour Costs) to Inflationary. Last year it was the market indicators, and primarily bond yields, that made us hesitate about predicting an immediate rise in inflation.  A year later, US bond yields have risen decisively, with 10-year bond yields categorically breaking up through 3% before falling back.  Other sovereign bond yields have not risen by much in 2018 suggesting that, outside the US, inflationary pressures are likely to remain muted.  We have therefore retained bond yields at Neutral. Monetary policy is very tight around the world except for China. The US Federal Reserve is in our view on the verge of making a policy error by over-focusing on inflation concerns.  This is how most recessions are caused, and we now expect at best a slow-down, at worst a recession.   Having said this, the Federal Reserve has softened its tone: while it is still talking further interest rate rises, Fed. Chairman Powell’s latest speech clearly prepares the ground for some backtracking.  Notwithstanding, we have moved this indicator to Deflationary.In summary, government fiscal policy seems inevitably to lead to higher inflation, but it is only coming through in some market and financial indicators.  Our 13 indicators have moved in different directions, with two (cost pressures and deleveraging) indicating more inflation and two (lower growth and monetary policy) signalling lower. Table showing direction of travel for inflation  Current market estimates of inflation The current IMF forecasts for Advanced Economies are little changed, whether in the short term or five years out, at 1.9% (deflator measure, 1.8% twelve months ago) and 2.0% five years out (end period CPI, 1.9% twelve months ago).  Estimates for Emerging Markets over the next five years average out at 4.2% end period CPI at the same time, compared to 3.9% 12 months ago.  US consumer inflation, as measured by the Personal Core Expenditure (ie. ex food and energy) was 2.2% in November 2018 (2.1% a year ago).  It peaked mid-year at 2.9% and has been falling back since. Conclusion In our view the final ditching of fiscal austerity, combined with the levels of debt in the West and an increased level of political dysfunction, bakes in higher inflation in the longer term.  However, in the short term the forces may actually be pulling in the other direction: we believe that the ECB and the Federal Reserve are on the verge of making a policy error by running too tight a monetary policy and economic growth has probably peaked this cycle.  That may be what market indicators, and particularly bond yields, are telling us. If you would like to discuss anything in this article with the author, please contact us.​