November market review
November market review
“Insanity is doing the same thing over and over again and expecting different results.” Albert Einstein
The Bank of Japan (BoJ) surprised markets as it announced an additional ¥10trn in annual asset purchases, just two days after the quantitative easing (QE) program concluded in the US. The European Central Bank (ECB) is also targeting an expansion in its balance sheet, opening the door for full-blown QE.
While financial markets cheer at the boost of liquidity, these measures may not ultimately lead to the self-sustaining economic growth sought by policymakers. Japan and the Eurozone need structural reform to deliver growth, rather than simply lowering bond yields. Easy liquidity may reduce incentives for governments to make difficult - and yet necessary - reform.
The blend of recent BoJ easing, more commitment from the ECB and a more hawkish Federal Reserve (Fed) supports our view of a divergence in monetary policy between the major global economies and is consistent with a further strengthening of the US dollar. A weaker yen effectively exports disinflation, raising the expectation of action by the ECB. As such, the euro will continue to face downward pressure.
Bank of Japan – Uncharted territory
Given the pace of QE, the BoJ’s balance sheet is likely to rise to over 70% of GDP by the end of 2015. The size of QE as a percentage of GDP in Japan is vast, even when compared to other nations such as the US (24%) and the UK (21%). The BoJ will increasingly buy higher risks assets, such as the new Nikkei 400 Index, in addition to Japanese government bonds. There is no doubt of the sentiment boost from QE, but we remain sceptical on the extent to which it can boost domestic economic activity.
We believe a fiscal policy error has already been made over the hike in consumption tax in April, as evidenced by the third quarter GDP report which put Japan in technical recession. Despite the scale of asset purchases conducted since 2013 and the associated yen depreciation, export volume, wages and prices remain stagnant. The second round of QE may have boosted markets in the short-term, but given the BoJ is simply repeating its actions from earlier this year, it is naïve to expect a materially different economic outcome. Structural reform remains key.
The combination of further easing by the BoJ and the Government Pension Investment Fund (GPIF)’s shift into domestic equities has been a catalyst for a rally in the Japanese market. However, the BoJ is moving into uncharted territory with its latest round of easing. With government debt already at over 240% of GDP, weak growth and deteriorating demographics, we are concerned about the longer-term prospects.
European Central Bank – Never say never
The ECB was surprisingly dovish at the November press conference: Mario Draghi has always stressed that the ECB does not pre-commit. Yet, he explicitly mentioned that the ECB balance sheet is expected to move toward its 2012 level. This would require an additional €1trn over the next two years. Looking at the historical level of the euro when the ECB balance sheet has been at around €3trn, the currency has room to depreciate.
The size of the asset-backed securities programme and longer-term refinancing operations (LTROs) are unlikely to be sufficient to achieve this target. Unconventional QE with potential purchase of corporate and sovereign bonds is therefore a real possibility.
Mr. Draghi also dismissed earlier speculation of a divided ECB. He stressed that there was unanimity from the Governing Council on expanding the ECB’s balance sheet. This has temporarily removed at least one hurdle to QE.
In addition, Mr Draghi revealed that the ECB is preparing for further measures if they prove to be needed. This is similar language to that used at the June ECB meeting, three months before the decision on ABS purchase. Hence the next significant policy announcement is likely to come in the first half of 2015.
Federal Reserve – Time to stop flip-flopping?
The latest Federal Open Market Committee (FOMC) statement was more hawkish than expected, as it noted that the slack in the labour market is gradually diminishing. No sweeteners were delivered despite the conclusion of the QE program. On the contrary, the normally cautious FOMC statement saw the addition of a number of hawkish comments. This contrasts with the dovish statement from just a month ago, which showed the Committee’s concern on a stronger dollar and external economic weakness.
We think the key phrase is “if incoming information indicates faster progress toward the Committee's employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated.” This expresses concern on current market expectations. We believe the market needs to recognise the improvement in underlying fundamentals from a broad range of metrics and adjust to the change in tone from the FOMC.
Incoming US data, particularly on the labour market, continues to support a more hawkish Fed. The FOMC has been holding back on hiking the base rate because of subdued wage growth and wage pressure is now building in the US: the latest employment cost index, initial jobless claims, nonfarm payroll and hiring intentions all point to a tighter labour market. If job creation continues to strengthen and wages show signs of greater acceleration, there is the risk of more abrupt re-pricing at the front end of the treasury curve.
Bank of England – Missing the sweet spot for first rate hike
The Bank of England (BoE) may have missed the sweet spot for the first rate hike. The first step of policy normalisation faces fewer headwinds if it is built on robust economic momentum. While we think UK growth is still strong, the pace is likely to be more subdued from here. The UK manufacturing sector is likely to be dampened by weaker sentiment and growth in the Eurozone. Meanwhile, the moderation in the housing boom will cool consumption activity.
We believe renewed concern on the Eurozone and subdued domestic inflation have delayed the prospect of a hike in the UK base rate. Policy tightening will now be a more difficult task given the loss in economic momentum and uncertainty from the upcoming General Election. While we think the Monetary Policy Committee (MPC) will continue to be divided, we have pushed back our expectation on a base rate hike to the fourth quarter of 2015.
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