10th August 2016
In some respects, last month’s Brexit vote seems like a lifetime ago. From its June 27 lows the FTSE has rallied over 1000 points in just over one month. Similar gains have been seen elsewhere in Europe, US, Japan. Not for the first time, central bank activity has trumped economic concerns in guiding market expectations. As government bond yields in Europe and Japan head deeper into negative territory, we are left asking the question, where to from here?
The Bank of England have certainly nailed their colours to the mast in respect to policy response. Mark Carney certainly struck a dovish tone citing policymakers had “considerable room” to ease policy if necessary, stopping short of advocating negative rates for now. On the fiscal side, new Chancellor Philip Hammond was Draghi-esque in indicating they would abandon the fiscal rule and “reset policy if necessary”. On the face of it, a combined policy response is the type of thing the economy needs in the face of the undoubted stiff challenges to come. The problem lies with the fact that it relies heavily on foreign funding of deficits at precisely the time when sources of this funding seem to be drying up (China, Middle East etc). The perception of the London property market as a haven for tax avoidance hasn’t helped coupled with the increased scrutiny in the wake of the leaked Panama Papers. In our view GBP will remain under pressure with a likely continuation of the downward trajectory. What this means for imported inflation down the line remains to be seen, and the Bank of England may have another dilemma on their hands in the not so distant future.
Coordinated fiscal/monetary stimulus we believe will become more prevalent in the future. In Japan, with a stronger Yen continuing to weigh on the economy, it is only a matter of time before we see more stimulus. With Abe now controlling a 66% majority in the upper house, he certainly has a mandate to go as far as he likes in terms of reflating the economy. In Europe, the problems continue to centre around the banking system as the “bad debt” issue remains unresolved. How the ECB deals with this remains to be seen, given they cannot provide liquidity to ailing banks without bondholders in some way getting burned. Whilst negative rates have helped asset prices, they certainly haven’t helped the banks. As in January/February time, bank profitability has once again come into the spotlight. The message the market is telling us is clear. Bank equity investors don’t like negative rates. ROEs have never been as low while some are trading at price to book multiples of lower than 30 cents. The same story does not ring true for the credit markets however. With CDS spreads on the same names remaining contained. Subordinated debt in fact on both bank and insurance names was a big winner over the month of July inspired by insatiable investor appetite for yield.
So, back to the thorny issue of yields. With $trillions of QE and negative rates having failed to revive growth/inflation, we would question the likely effectiveness of yet more. So from this perspective, as we have mentioned in previous commentaries, we are not surprised to hear of fiscal stimulus plans. And what of the Fed? Perhaps it is they who find themselves in the most difficult position. The broader outlook (June payrolls, strong financial markets etc) would seem to support a more hawkish stance than what markets are currently anticipating. Whilst they are admittedly unlikely to hike in September, December could be a possibility. They may not get many more chances. All-time highs in equities, all-time lows in bond yields. In the short to medium term then, we would not be surprised to see yields continue to grind lower. Whatever the eventuality, even at these levels there is a considerable amount of duration risk being run for very little upside. The risk is asymmetric. So whilst rates can grind lower, we do not believe current levels offer adequate compensation. However it does not take much for markets to re-price. The Fed talking up the dollar, higher inflation expectations, or simply thin market liquidity over the summer months. This is exactly the type of volatility that we will be looking for to lock in higher yields for our investors.
By Steven O’Hanlon