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Turnaround?

1 February 2019

The first month of 2019 is over already and the new year has brought quite a remarkable turnaround for investors compared to the last month of 2018. Global equity markets have recovered to the tune of 7%, but most other asset classes have done so as well which is just as rare as was last year’s return dearth across the board. After taking in the January 2019 asset returns as per our regular table below, UK investors are forgiven to suspect Brexit shenanigans to be responsible for having missed out. The opposite is the case: £-Sterling has risen on the back of optimism for a softer Brexit amongst international investors and this increase in the pound’s purchasing power abroad makes up the difference.

We have written over the past weeks how this capital market turnaround must seem incomprehensible to outsiders, but that it has as much to do with global liquidity conditions easing as last year’s sell-off had all the hallmarks of a distinct liquidity squeeze. This week then, the most watched provider of monetary liquidity for global financial markets – the US Federal Reserve central bank – indicated that they would be likely refrain from further interest rises for the time being. They even went further than markets had hoped and hinted that they may scale down the rate at which they are reducing their balance sheet and thereby the US$ in circulation through quantitative tightening (QT).

The rate pause announcement fulfilled market expectations of the last weeks that the US Fed was not about to commit a policy error through continued rate rises when the US economy was clearly slowing and thus reducing the risk of inflationary pressures from economic overheating. However, the hint that they may also slow down the reversal of quantitative easing (QE), if required, got capital market commentators and analysts very excited.

This is because there has long been an observation that if capital markets show any sign of stress – like last year end’s sell-off – then the central bank will come to the rescue and protect investors from suffering too harsh a fall. Ultimately, these voices argue, this leads to irresponsible risk taking by overly confident investors which causes asset bubbles and much more severe collapses of part or all of the financial markets. The Global Financial Crisis of 2008/2009 (GFC) and the commodity market collapse of 2014/2015 are cited as validations.

We would agree that to capital markets this 180 degree turn by the Fed, compared to their December statement, must seem like a return of too soft a central bank stance, given markets have already recovered and a pausing of further rate rises should have sufficed to keep them relatively stable. However, to our mind the scathing critique from capital market commentators is simply an expression of their self-important assumption that Fed actions are primarily aimed at them rather than the economy.

As we discuss in the second article this week, the US economy has slowed much faster and more broadly than had been previously forecast and as a result the US central bank no longer saw reason for slowing the economy through monetary constraint. As we have written before, the unwind of the extraordinary monetary easing measure of QE through QT is as much uncharted policy territory as QE was in the first place. Central banks simply cannot know how much reduction of primary monetary liquidity is adequate and necessary to prevent the next (aforementioned) asset bubble from building and/or the economy from overheating.

2018 has taught US central bankers that they may have slightly overshot target, once adverse rather than stimulating ‘Trump effects’ entered the equation. Now that low grade credit provision through leveraged loan instruments has markedly slowed and equity markets no longer trade close to bubble territory, they have relaxed and are willing to support US businesses with lower cost of capital to cope with the Trumpian headwinds. This bodes well for stock markets who have tended to perform well during economic slowdowns that were accompanied by accommodative monetary policy.

Before anyone gets too carried away in their market optimism, such central bank intervention could prove quite temporary. Should the main economic worry points of trade tensions between the US and China and a disorderly Brexit be resolved then we are likely to experience a profound enough reacceleration of the global economy for central banks to just as swiftly resume their monetary tightening course.

From this turnaround angle, Trump’s optimistic announcements that a breakthrough in the US Sino trade negotiations are imminent could be a first sign that there may indeed be light at the end of the tunnel. The UK parliament’s ability to unite behind a proposal rather than a rejection could be interpreted as another positive. The muted market reaction to either tells us that ‘Mr Market’ foresees more pain before there may be gain. For the moment we welcome the FTSE100 back above the 7,000 index mark, but caution investors not to overinterpret January’s positivity as the likely market trajectory for all of 2019.

The easing of liquidity has certainly helped to pull asset valuation up from the oversold conditions of last year. However, for January’s partial recovery to turn into a full recovery and beyond, we will need to see a sustained turnaround in economic momentum from slowing, back to accelerating. From such a perspective we just about make out tepid signs of improvement in certain economic indicators, but together with other less positive macroeconomic data flow this currently amounts to no more than an inkling that we may have reached the low point of this mini-cycle.

Capital markets tend to look ahead and it can therefore be argued that the current slowdown has already been reflected in the disappointing 2018 returns. While this may well be so, it is also true that for a positive first month to turn into a positive year overall, there are still many hurdles and sources of renewed doubt ahead to make further market developments all but smooth.