Richard Jeffrey was Chief Economist at Cazenove Capital until he retired in January 2018.
Strategy & economics
The greatest challenge facing advanced economies during the next phase of the recovery cycle is to establish stronger productivity growth. While headline activity numbers for many economies may have looked dull at best, the accompanying gains in productivity have been even more disappointing. One positive consequence of the weak trends in productivity has been that the rate of job creation associated with even fairly modest GDP growth has been much greater than would normally be expected. As a result, labour markets in countries such as the US, Germany and the UK are now looking very tight. Another, but less helpful, consequence of poor improvements in productivity is that inflationadjusted per capita income growth has been weak. This helps explain why there seems to be increasing dissatisfaction amongst employed people; although economies are growing, the average employee does not feel an improvement in living standards.
For central banks, the current situation presents a conundrum: why are companies not undertaking much higher levels of productivity-enhancing capital investment at a time when short and long-term borrowing costs are so low? While there are many possible explanations, one in particular questions the efficacy of unconventional monetary policy - the combination of quantitative easing (QE) with exceptionally low or even negative interest rates. In more normal times, we might expect to see interest rates and bond yields of around 4%. Companies wishing to raise capital or maintain positive share-price momentum would have to offer a return in excess of the ‘risk-free’ rates. Returns to equity investors come from three sources:dividend yield, growth in dividends and capital growth. However, we are not in normal times. Compared to the current exceptionally low returns from ‘risk-free’ cash and bonds, the running yield on equities is sufficient, in itself, to make equities the more attractive asset class. This reduces the incentive on companies to undertake capital investment projects that, inevitably, involve a degree of risk. In effect, therefore, very low interest rates may be a cause of corporate lethargy.Excessively easing monetary conditions may have been counterproductive in other ways too. Central banks, however, have recently remained extremely risk averse. This has been particularly true in the US, where the Federal Reserve (the Fed), having projected a number of interest rate rises in 2016, did not move until December – the first anniversary of the initial very tentative move towards policy normalisation.
While the Fed has found adequate reasons to procrastinate, the European Central Bank has judged economic conditions to be sufficiently weak to justify continuing its programme of QE, reinforced by the adoption of negative interest rates. The same has been true in Japan, where the authorities have persisted with the use of cyclical policy tools to address what are deep structural problems in the economy. Meanwhile, in the UK, in the face of an unexpected result in this summer’s referendum, the Bank of England cut rates to 0.25% and resurrected its QE programme. QE has long been expected to be inflationary – some will argue that it has already been, through rising asset prices, but this is not conventionally regarded as inflationary. During 2016, there have been hints that inflation might be about to become more widespread. While it had been the case that global overcapacity in elements of the supply chain had been putting downwards pressure on prices, this is now less obvious. Energy and other commodity prices have risen during 2016, and manufacturing based economies (particularly those in Asia) have begun to adapt to weaker demand trends in advanced economies. At the same time, there is evidence that tighter labour markets are beginning to be reflected in higher employment costs, particularly in the US.
Putting these various arguments together suggests what might seem a rather weird transmission mechanism between unconventional monetary policies and the price level, the connection being made through the low productivity growth that is currently evident.
If this is true, then rather than something to be feared, the gradual normalisation of monetary policy is something that should be welcomed, as it should be accompanied by improved gains in productivity, and ease the strains evident in certain labour markets. While second-guessing central banks has been difficult in recent years, it does now seem that the Fed will begin to step up the pace of tightening in 2017, although it seems unlikely other central banks will follow their lead. The biggest issue for central banks in 2017 is likely to be inflation, and whether incipient cost and price rises become more obvious. Only then will markets learn the inflation tolerance of central banks.
In terms of growth, in the face of disappointing outturns in many economies in 2016, economists have been cutting forecasts for 2017. This has been particularly true for the UK, where it is estimated that the Brexit growth penalty would be around 1% in each of the next two years. More generally, we believe that forecasts for growth in advanced economies in 2017 may now have been reduced too far. We would expect the US to top the G7 growth league, building on the momentum gained through the second half of 2016. The additional angle that will need to be watched however, is the impact the incoming president’s policies may have on both domestic and world growth.
Ironically, despite dire prognostications in the immediate aftermath of the referendum, in 2016, the UK is likely to be the fastest growing country in the G7. While a dip in growth does seem probable in 2017, we believe the downside risks to activity are currently overstated. For the eurozone, the north/south contrast is likely to remain evident in an overall growth rate that is set to remain sub-optimal. Japan also seems likely to remain mired by the deflationary forces that have depressed growth over the past 20 years.
Overall, this implies 2017 growth at a similar pace to 2016 for advanced economies. For emerging economies, this makes for a similar demand backdrop in the year ahead, although these economies have been adapting to the changed pace of western growth, and are now looking more resilient. While the banking system in China remains stressed, growth seems to have stabilised (albeit at a lower rate than the official target), and prospects for other countries in the area are also improving. One interesting turnaround that may be seen in 2017 is in Brazil, where, finally, the economy is expected to emerge from recession.
Investment markets in 2017 may also see a continuation of trends from 2016. Equity markets started 2016 in a volatile fashion based off concerns about global disinflation and near-term political events. Yet perversely, when the feared ‘negative’ outcomes unfolded (the Brexit vote, Trump’s victory and failed Italian referendum) markets generally dismissed the forecasted negatives in an increasingly rapid fashion. The key to next year’s overall returns, however, may well be investors’ perception of inflationary risks and the behaviour of bond markets.
Investor focus has switched last year from fears of disinflation/ deflation to worries of rising and potentially persistent inflation. The perceived wisdom for a large part of the year was for continuing disinflationary forces globally, so much so that 10 year gilt yields fell to 0.50% post-Brexit. However, as economies showed resilience, labour markets continued to tighten in several key advanced economies, oil rebounded and fears of disinflation gave way to expectations of the return of inflation. This repositioning resulted in a sharp fall in bond prices, particularly in the UK and US from late summer onwards. Despite UK 10-year yields almost tripling from their lows, they still ended 2016 below their starting point, while yields in the US ended the year higher.
As mentioned, one of the key drivers of investment markets in 2017 will be the reaction of the bond markets in the face of continuing strength in economies, the US in particular, and the impact it has on interest rates. Any sharp increase in bond yields will not only lead to losses in fixed income holdings but will also threaten the valuation support to other asset classes. The style rotation we have seen in equity markets, from growth to value, is also likely to continue this year as investors focus more on cyclical exposure and shift away from defensive bond proxies.
Parallel to the bond market reaction is the strength, or otherwise, of the US dollar. While a number of factors point to a stronger dollar (for example the strengthening economy and interest rate differential), this is a consensus view and thus may largely be positioned for. Despite this, 2017 may well be a continuation of 2016 where currency returns strongly influence investors’ total returns, driven by changing regional expectations of economic growth, inflation, interest rate differences and of course politics.
With growth rates better but still relatively dull, overall investor returns are not likely to be as exciting as 2016. If we do get headwinds from higher bond yields, this may mean a choppier year ahead, however, as longer-term investors, we should view volatility as potential opportunity.
Richard Jeffrey was Chief Economist at Cazenove Capital until he retired in January 2018.
Chief Investment Officer
Caspar Rock joined Cazenove Capital in September 2016 and is Chief Investment Officer. He joined from Architas Multi-Manager Ltd, a part of the AXA group, where he was Chief Investment Officer and responsible for all aspects of the investment activities, including investment philosophy, process and team. He also oversaw portfolio management at two of AXA group’s private banks. He previously headed up the multi-manager business at AXA Framlington from 2006 to 2008. Prior to that, he managed a range of directly invested equity and bond portfolios, and was Head of European Equities at Framlington as well as a member of the Healthcare team. He has 29 years’ investment experience.
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