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17 December 2018
By Jim Leaviss
The decade since the financial crisis has been defined by quantitative easing (QE). Under QE, central banks have bought up assets, mostly government bonds, to encourage investment elsewhere in the economy and thereby support economic growth.
If you think this has been effective, it follows that you should expect asset prices inflated by QE to now be gradually deflated, to some extent, by central banks tapering their support.
The removal of this stimulus, which has already begun in the US – where interest rates have also been on the rise – and will follow shortly in Europe – where the European Central Bank is ending its bond purchases – can naturally be expected to have a negative impact on economic growth in the near term.
The health of the US economy shapes global markets, so I watch several indicators closely. Despite strong growth recently – the economy expanded at an annual rate of 3.5% in the third quarter of 2018 – there are a couple of red flags that could signal a downturn.
Firstly, the housing market, where unsold inventory of homes has risen to seven months of demand – the highest level since 2011. The housing market is especially important since home-buying has a strong multiplier effect on the wider economy, in the sense that people tend to spend money on related goods and services when they move. A slowdown in the housing market therefore leads to lower spending in other parts of the economy.
Secondly, car sales continue to fall, and not just in the US. Globally, they have fallen around 10% year-on-year amid rising tariffs on car imports in China and the “Diesel-gate” emissions scandal in Europe. Many economists regard falling demand for new cars as something of a “canary in the coal mine” since it is a good indicator of consumer confidence.
If US economic growth were to stumble, there are concerns that President Trump’s hands may be more tied than previously, having already enacted a series of tax cuts in 2017. The US government’s yawning budget deficit may limit its ability to respond to a downturn with emergency spending, although there could be Congressional support for infrastructure investment that would boost demand in the economy.
Jerome Powell, chairman of the US Federal Reserve, is coming under pressure from Trump to slow down what the president sees as the Fed’s aggressive pace of rate rises. This pressure will increase if stockmarkets continue to fall. Powell has proven resilient so far, but it might put the brake on further rises. Central banks might realise that they don’t have as much in the toolkit as before.
The spread, or premium, between the investment returns available on corporate bonds above US government bonds drifted wider in 2018. The upside of rising yields on corporate bonds is that the prospective returns for investors going forward appear more attractive than they did.
The fundamentals of the investment grade corporate bond market look sound since the number of companies defaulting on their debt remains low, relatively speaking. While the end of the European Central Bank’s corporate bond-buying programme will have a negative effect on demand, at least the growth in supply is curtailed by limited new issuance.
For investors willing to take on more risk, I think there is also some value in emerging market bonds.
I think it is imprudent for investors to try and second-guess what form Brexit will ultimately take, and what its implications will be, since politics is so demonstrably unpredictable. Nonetheless, we should be mindful of two factors that may limit the fallout.
Firstly, the pound is already looking undervalued versus most global currencies. The extent to which negative expectations are already baked in to asset prices today does at least limit the potential downside for investors.
Secondly, the Bank of England will be mindful of both how indebted the UK consumers are – households are barely saving – and how quickly any interest rate rises filter through to borrowing costs, hitting spending and therefore growth. We might therefore expect moderation when it comes to how much interest rates can rise in 2019.
The views expressed by the author should not be taken as a recommendation, advice or forecast.