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Given how poor the recent economic data has been, it seems logical to attribute the recent strong performance of risk assets to lower bond yields. In other words, a slowing global economy (and subsequently lower forecasts for corporate earnings) is offset by a lower risk-free rate (which increases the present value of future cash flows). This market logic would seem to dictate that the worse the economic news, the more that global central banks will have to do in response (via lower rates) and therefore the more that assets will be worth?
This is all well and good, of course, so long as central banks are both able to respond and prepared to do so. In January, in response to some very weak global trade data, a hitherto hawkish US Federal Reserve performed a complete U-turn. This was then followed by dovish language from the governors of the European Central Bank and Bank of Japan. But how far can central banks go? Negative (nominal and real) rates make perfect sense in economic text books, but in practice appear to have been rather less effective when one looks at the experience of Japan and Europe? Because central banks have been unable to ‘normalise’ interest rates since the last cycle, they have little scope by historic standards to ease should the data deteriorate further.
In addition, political pressure is mounting (including what The Economist has labelled as Millennial Socialism) to limit the use of extraordinary monetary policies such as quantitative easing. This monetary experiment has subsequently been judged (by commentators, politicians and central bankers alike) to have exacerbated inequality, by enriching the haves (via rising real asset prices) at the expense of the have nots.
The fact that market volatility remains low, appears to be another sign that markets believe that the world’s central banks are still in full control. Despite a dramatic risk-off move in December, the weak economic data and the significant geopolitical issues that dominate the front pages of the newspapers (such as US -China trade relations, Brexit, Kashmir, Iran, Korea), the VIX equity volatility index is still well below its long-run average. Bond spreads continue to tighten too, another sign that markets are ignoring the underlying data.
So, what might potentially jolt markets out of their current state of apparent complacency? The most obvious catalyst would be if the trade talks between the US and China failed to produce more than a set of headline aspirations. The delay to the 1 March deadline for the imposition of higher tariffs undoubtedly caused the markets to discount a significant cessation of tensions. It is unlikely that a Chinese offer to buy more American goods and agricultural products will not satisfy Washington, given that both sides of the political aisle have made clear that they want deeper access to Chinese markets and greater protection for intellectual property.
The next highest risk is if a recent attempt by the Chinese authorities to stimulate growth fails. China has undoubtedly eased credit conditions at the start of 2019, but it is not clear that the authorities have completely abandoned longer-term stability imperatives in favour of short-term growth (given the 2018 efforts to reign in exponential debt growth). The recent stimulus is certainly nowhere near the levels seen in 2009 and 2015. Additionally, the marginal benefit of each unit of credit creation has been diminishing, so the latest efforts might not be sufficient to offset private sector deleveraging and slowing global trade.
Finally, might growth expectations make a return in the US? Although data in the US has softened a little, it has not slowed nearly as much as the rest of the world. Meanwhile the labour market remains buoyant and the US 30-year Treasury yield is back around 3.1 per cent, signalling that US recession fears are ebbing. More signs of US wage inflation and the Federal Reserve might not prove to be quite so dovish after all.
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