Mind the Gap

6 min read 7 Sep 20

Summary: In this month’s video and blog Investment Specialist, Kirsty Clark comments on the Fed’s move to ‘average inflation targeting’ and how government and central bank liquidity has been ‘bridging the economic activity and earnings gap’, fuelling market gains through the COVID crisis.

The combined tailwinds of fiscal and monetary stimulus, along with continued optimism around vaccine progress, saw global equities deliver their strongest August gains in over 30 years.

The ‘risk on’ rally drove global equities into new bull market territory, as indices fully recovered their COVID-induced losses. During the month, the MSCI AC World Index was up more than 6% in US dollar terms.

Japanese equities were the standout performers in August, despite selling-off on the final day of the month after reports that Prime Minister Shinzo Abe would step down due to health concerns.

In the US, presidential campaigning got underway and equity markets continued their upwards climb. The ‘tech-heavy’ NASDAQ Index delivered double-digit gains, and the S&P500 Index closed up over 7% after Federal Reserve (Fed) Chair, Jay Powell announced the central bank’s intended shift to an ‘average inflation target’.

The US dollar weakened against the euro, sterling and the Japanese yen. US 10-year treasuries and German 10-year bunds also lost ground, while lower rates continued to drive investors up the risk curve, supporting global high yield bonds.

Gold managed to surge past $2,000/oz before finishing marginally down at the close. It remains one of the strongest performers year to date, up around 30%.

At a sector level, consumer discretionary and tech stocks were the strongest performers. Shares in Walmart jumped after reports it was partnering with Microsoft to bid for the US arm of video sharing app, TikTok. Traditionally defensive sectors including healthcare and utilities lagged the wider market.

Heading into the final week of August, global equity markets hit new highs as the liquidity backstop, provided by governments and central banks globally, fuelled ongoing investor risk appetite.

With investors expecting ‘more of the same’ central bank largesse to help ‘bridge the activity and earnings gap’ – and due to addresses and discussions moving online – the usual interest around the annual Jackson Hole central banking symposium was tempered.

Speaking at the virtual conference, Jay Powell said the US central bank would shift to an ‘average’ inflation target – allowing inflation to exceed its 2% target for periods of time to offset past shortfalls.

In practice, since the Fed formalised the 2% inflation target in 2012, US inflation has not sustainably reached its target, except briefly during 2018.

However, the additional flexibility will mean that when inflation runs below target, for instance, the Fed can shoot for inflation temporarily above 2% to make up for the undershoot, while still aiming for 2%, on average, over time.

The move was a departure from the Fed’s historical approach, but the dovish shift was widely expected and the market reaction relatively muted. With core inflation currently well below target and the economy operating below full capacity, rates will likely stay lower for longer.

The Fed also reframed its views on the labour market and the level of employment that can be maintained without leading to “an unwelcome increase in inflation”. It will now look at “shortfalls” from maximum employment levels rather than “deviations” one way or the other, reflecting the view that a robust job market can be sustained without causing an inflation overshoot. Jay Powell also stated that the new goal was “broad-based and inclusive”, in an effort to address economic inequality in the US.

The Fed pivot recognises the breakdown in the historic relationship between inflation and unemployment in recent years, as characterised by a flattening Phillips curve, and taps into the long-standing debate around its continued efficacy as a tool for setting policy and forecasting inflation.

The need to stand ready and broaden monetary policy response to support our economies during the downturn was a sentiment echoed by the Chief economist of the European Central Bank, along with the Bank of England governor Andrew Bailey.

Meanwhile, the Bank of Canada governor called for greater transparency from central banks to help preserve public confidence amid the growing swathes of misinformation. The central bank is to seek public input for the first time on its inflation target.

Central banks globally have slashed interest rates and turned to unconventional monetary policy tools to deal with the COVID-19 crisis. We have also seen central bankers review and reassess longer-term monetary policy responsibilities to address changing global dynamics, and better meet future economic and societal needs.

Notably in Europe, ECB President Christine Lagarde has pushed to include climate change considerations into the way the central bank conducts its monetary policy. In the UK, former Bank of England governor Mark Carney launched the bank’s first climate-related stress tests while he was governor.

Some broader interpretation of responsibilities will be welcomed by economists who have long called for central banks to adopt greater flexibility and move away from focusing solely on price stability through inflation targeting, to take a more nuanced approach that better marries policy response with economic reality.

So far, the great monetary experiment has proved successful in bridging the economic activity and earnings gap.

Meanwhile, recent economic data has shown signs of recovery and earnings, for the most part, have surprised to the upside. However, risk assets could come under renewed pressure if investors begin to question the commitment of policymakers or, indeed, if hopes of vaccine progress are derailed.

For now, markets will be looking to the forthcoming September Federal Open Market Committee (FOMC) meeting for further details on how the Fed plans to implement its newly-stated policy objectives.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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