16th August 2017
The correlation between the record breaking rise of ETFs, the inexorable march of stock markets to new highs and the fall of bond yields to new lows is striking. Backed by years of abundant liquidity, investors have become conditioned to “buy on dips”, hungrily hoovering up any temporary blip in risk asset prices. The question we are repeatedly left pondering then, is can this cycle break and if so what will break it?
So, we once again find ourselves back at the source; central banks. That monetary conditions have remained so loose for so long cannot be denied, nor can the simultaneous rise in risk asset valuations. This has no doubt helped perpetuate an environment of risk taking, with investors secure in the knowledge they are backed by $trillions in global central bank balance sheets. So much so in fact, that markets seem wholly unperturbed by central bank attempts to signal a return to tighter monetary conditions.
All Eyes on Wyoming
So where to next? The Jackson Hole symposium last made real headlines back in August 2010 when Ben Bernanke signalled the beginning of QE2, and with it a resurgence in market risk taking after deflation had threatened to derail the nascent recovery. It seems there is a similar level of anticipation this time around. With Mario Draghi set to address policymakers, many expect the ECB to provide the headlines. While recent reports have suggested Draghi will not deliver fresh policy, the fact remains he is in a tricky position. While headline data in the eurozone has certainly picked up (GDP, inflation, employment), so too has the Euro, which has begun to weigh on exports and by association European stocks. Adding to this is the fact that the ECB is physically running out of assets to buy as part of its QE programme. What are the options? Reduce the pace of purchases prompting further Euro strength? Or broaden the scope of the QE programme – something they have previously stated they will not do – forcing yields even lower. Of course, the Fed could provide a helping hand. No doubt US equity markets have benefitted from a weaker USD of late, offsetting to some degree Fed talk of monetary tightening. Were they to err on the side of more hawkish rhetoric, a stronger dollar could certainly take some of the pressure off their European counterparts.
However, the Fed have their own dilemma. Whilst employment continues to signal a tight labour market, the absence of inflation in the system is causing policymakers to scratch their collective heads. It would also appear to be holding back market expectations of higher inflation. The traditional Phillips Curve relationship between employment and inflation seems to have broken down, as the proliferation of lower paid, service based employment fails to feed through to higher wage growth. On this basis it may be difficult to envisage a more hawkish Fed than expected, although they would surely appreciate the ammunition in terms of higher rates come the next recession. So what then should we expect? If the over-arching goal be a continuation of easy market liquidity conditions, the above discussion is somewhat irrelevant. So, we’re once again back at our initial question. What (if anything) will be the pin that pricks the central bank bubble, if not the central banks themselves?
A word on China here: The PBoC has certainly been a major player in the central bank liquidity story. The credit bubble witnessed in China post the financial crisis has been nothing short of colossal. The shadow banking sector is now as large as $37 billion according to some sources. Yet in the midst of all this stimulus, signs that liquidity conditions are beginning to roll over are evident. As we have mentioned in the past, the UBS credit impulse (led by China) has declined by some 6% of GDP in the past 6 months. Meanwhile recent data on retail sales, industrial output and fixed investment all missed estimates. Whilst it might be early days, these all prompt the question of whether the market has simply reached exhaustion point. Broadening this analysis, and absent any significant exogenous shock, could it simply be the case that buyers eventually run out of things to buy? Can a bull market die of old age?
By Steven O’Hanlon
The views above are published solely for information purposed and are not to be construed as a solicitation or an offer to buy or sell any securities, or related financial instruments. It does not constitute a personal recommendation as defined by the Financial Conduct Authority (“FCA”) or take into account the particular investment objectives, financial situations or needs of individual investors. The views above are based on public information and sources considered reliable.