The King is Dead, Long Live the King

Multi Asset
Matt Sherwood

Matt Sherwood

Head of Investment Strategy

Despite three decades of successful policy implementation, the power of central banks to lift economies and financial markets is now looking increasingly shaky. Notwithstanding widespread stimulus and ultra-accommodative policy in most parts of the world over the past seven years, the recent sharemarket volatility has highlighted the limitations of monetary extremes to lift asset valuations in a structurally slowing world.

Matt Sherwood, Perpetual’s Head of Investment Strategy, Multi Asset examines this and concludes that the primary investor concern has been the possibility that the emerging market slowdown may spillover into advanced economies and dampen earnings expectations at a time when valuations remain above long-run averages. While market corrections are a normal part of the investment cycle, sustained bear markets ultimately require global recessions and investors loss of faith in central bank’s ability to lift valuations would have to broaden to have them doubt the former’s ability to lift growth for this to be the case.

Introduction

Over the past three decades central banks have gone from managing the overnight cash settlement system to being ‘masters of the universe’. The increased importance of central banks began in the early 1980s with inflation targeting after the second oil shock and was underpinned by their ability to impact household disposable income and exchange rates. This power grew in what turned into the largest and longest leverage boom in history and many investors now believe that central banks can prevent depressions, move markets, impact prices and overcome any oppressive economic force. While this view is wide of the mark, there is no doubt that economic volatility has declined markedly during their extended financial market reign.

Central bank power has declined

In recent years monetary policy has proved to be ineffective in its ability to generate enough cyclical economic upswing to overcome the structural forces of waning demographics, declining productivity, balance sheet impairment and declining trade growth. Even in the US, where the post-GFC recovery is strongest and most advanced, record low interest rates and three QE programs have culminated in the weakest recovery in US history. In China the problems are more pronounced with the economy slowing notably with nation-wide debt having doubled over the past eight years, the exchange rate having risen against all major trading rivals and banks having rising non-performing loans despite being recapitalised and cleansed over the past decade. Indeed, the massive over investment in real estate may only be the tip of the iceberg given how much corporate leverage has grown in industries which are now characterised by weaker growth and chronic excess capacity.

Central banks can’t lift inflation

In the end, it is clear that central bank’s ability to drive growth and control inflation is waning, with disinflation impacting all major economies given the surge in investment in economic capacity in response to weak growth after the GFC. Despite ultra-accommodative policy settings with zero interest rates in most advanced economies, and QE programs in the US, Japan, Europe and the UK, disinflation and deflationary pressures have clearly had the upper hand in recent years. Indeed, record numbers of OECD countries have inflation below 2% and 1% (see Chart 1) and 14 of the 15 largest advanced economies have inflation below 2% (which is the lowest number ever outside the GFC).

While lower oil prices have added a cyclical component to the disinflationary forces clearly at work, it has only enlarged the record number of low inflation countries that existed when the oil price was at USD100 per barrel 12 months ago. Low inflation instead reflects the structural forces of higher debt, low productivity and poor demographics. Even when the cyclical elements dissipate, I cannot see monetary policy suddenly regaining the potency it has lacked in the past six years and in that way the path to policy normalisation in the US is a very long one and one thwart with heightened dangers. In fact, since 2009 nine central banks have begun tightening cycles and nine were forced to ease again when growth stalled and deflation risks rose. In this way, any back up from bond yields from any US rate hike is likely to represent a buying opportunity for investors.

 

CHART 1: GLOBAL DISINFLATION IS RISING

CHART 1-GLOBAL DISINFLATION IS RISING-SEPT15


… but they can weaken growth

While central banks can’t improve the state of the global economy or increase inflationary pressures, policy mistakes can generate asymmetric risks. In this light, the US Fed would be foolhardy to think it can raise rates without ramping up risk premiums given the current market stress, as growth and inflation are low globally and the costs of policy mistakes are rising. Cheap monetary policy alone is not our saviour this time around and governments need to address the structural constraints to growth instead of asking others to do it for them.

Central banks’ ability to create an environment which is constructive for equities is being tested at present and the outlook on that front looks increasingly clouded. Although it’s painful to go through for investors, the latest market correction is typical during an ageing bull market. There are clearly worrying trends given waning growth prospects and declining inflation and the fear for investors is that the China and emerging market slowdown could broaden and engulf advanced economies at a time when central bank policy is impotent and investors have little faith in global political leadership.

Market correction or economic infection?

The key for investors is determining what sort of environment we are in. The global sharemarket has declined by -12% since May, which is slightly less than average (-14.5% since 1970) and history shows that -10% corrections have occurred in 29 of the past 45 years (see Chart 2). History indicates that if the decline can remain less than -20% the average calendar year return is +9.8% since 1970, with 14 of the 17 years recording gains (the only exceptions were 1981, 1992 and 2000).

The bull market is over

Conversely, if the intra-year decline is greater than -20% the average return declines to -9.4%, with 8 of 11 years recording losses (1987, 1998 and 2009). The key for those three years was that the global economy recorded a solid expansion, so bear markets are hard to sustain without a global recession and that at present seems unlikely in advanced economies. However, corrections are the part of every cycle and for an analyst to say that this one is over and that markets are likely to trend higher from here, they would have to be confident that both the valuation downgrade is completed and that earnings are likely to rise. Indeed if investors have downgraded central bank abilities to boost asset prices, I remain sceptical that the end of the valuation correction will prompt a resumption of the four year bull market as earnings growth is weak across the board, cost cutting is limited in all business operating models and the cyclical upside is limited due to structural factors.

 

CHART 2: MARKET CORRECTIONS ARE COMMON

CHART 2-MARKET CORRECTIONS ARE COMMON-SEPT15

 

Implications to investors

Investors should not be complacent about the China and EM growth moderation. Markets corrections are a normal part of the cycle and if we remain in stage three of the cycle (a mature bull market) history shows it pays to purchase any market correction, if however we have moved to stage four (global bond and equity bear markets) it pays to sell any market bounce. The fortunate two things are that the US Fed is unlikely to lift rates in September which should provide markets with increased confidence of avoiding a policy error, and also that China has plenty of policy stimuli it can unleash. The problem for China is that bank non-performing loans are rising and the more indebted a country becomes the more difficult it is for the central bank to stimulate growth through interest rate policy. In Australia, the economy looks very subdued as the mining investment unwind continues and central bank stimulus here (and abroad) is not enough by itself to build a sustainable recovery. Instead, the solution involves a co-ordinated government effort to address the structural constraints to growth and inflation, but without this, cheap monetary policy will only serve to inflate bubbles which ultimately become self-destroying for the growth outlook.

 

KEY TAKEOUTS
  • The old saying in financial markets of ‘don’t fight the Fed’ is underpinned by an assumption that central banks can control and manage asset prices at various points of the investment cycle. However, this view is being tested currently as monetary policy has proved to be ineffective in generating enough cyclical economic upswing to overcome the structural forces of waning demographics, declining productivity, balance sheet impairment and declining trade growth. It is clear that central bank’s ability to drive and control the economic cycle is waning as balance sheets are so over-leveraged and the forces weighing on growth are structural in their nature.
  • Whilst painful for investors, the recent market correction is not unusual especially for an ageing bull market. The base fear for investors is that the economic slowdown and financial stress that is clearly underway in emerging markets will have spillover effects into advanced economies. There are clearly some worrying developments but the key for investors is how far the current -12% global sharemarket decline goes, because the average return for a year which has an intra-year decline between -10% and -20% is +9.6% since 1970 (with 13 of 16 years recording overall gains), but if the intra-year decline is -20% or more the average return is -9.4% (with 8 of 11 years recording losses).

 

Matt Sherwood
Head of Investment Strategy, Multi Asset
Perpetual Investments