In the review of our first year, we noted the considerable ongoing geopolitical events but concluded that the biggest threat to stock markets was that the US Federal Reserve raised interest rates too quickly. Indeed, since our analysis in September, this very risk has played out somewhat as an incredibly hawkish “Fed” has indicated a highly aggressive stance on raising interest rates. This caused a mini-tailspin in equity markets in October which saw both our Fund and benchmark fall by high single digits.
Donald Trump has been widely condemned for his criticism of the Federal Reserve for raising rates so quickly or “going loco” as he put it. Whilst his challenge to central bank independence is unwelcome, we believe he is not wrong on the point he makes.
So how is the world currently set-up for a more restrictive monetary policy?
In the US there has been a strong recovery from the financial crisis in terms of jobs growth and asset prices. However, government debt has swelled to help fragile households deleverage whilst wage growth and core inflation have been subdued for a long time and only recently seen a meaningful pickup. A sustained period of strong wage growth is desperately needed, even if it means living with slightly above target inflation in the short-term, to recapitalise poorer households and counter populist feelings.
Across the Atlantic, since the financial crisis the Eurozone has never really ceased being a toxic mess. The current framework of monetary union without fiscal union together with nation state democracies is completely unsustainable and those in power seem extremely unwilling to enact significant reform. Italy is just the latest chapter in a saga where a permanent solution is difficult to envisage. Mario Draghi gave the region some breathing space in 2015 through the ECB QE programme but the EU have largely squandered this and the ability to act in a similar manner again is now greatly diminished. The EU institutions are world-class “can kickers” so they may be able to fudge their way along for now, but the bloc remains extremely fragile and tighter monetary policy is certainly not needed at present.
Over in China, to understand where they are now it is worth recalling their role in the global recovery from the financial crisis. Pre-2008, China had a booming export-driven economy which feasted on the exuberant growth in consumption in the west, driven by an unsustainable housing boom. A sharp drop in demand for exports during the crisis severely dented this Chinese engine of growth so they quickly found a new one in the form of a massive debt-driven investment boom. This put Chinese men and women back to work, continued to drive prosperity and provided a big boost to global growth just when it was needed. However, as China attempts to transition their economy once more, away from investment and towards consumption, the legacy of historically wasteful investments and bad debt together with political conflicts with the west provides multiple speed bumps ahead. To ease this transition, monetary accommodation is needed. It certainly does not need tightening.
Japan, once a pillar of the global economy, has wasted away in prominence. An extremely old population is a drag on demand which overall is terrible and needs constant life support from the Bank of Japan.
So, in the face of all this, the Federal Reserve has decided it’s a good idea to pursue a “restrictive” monetary policy by aggressively raising short-term interest rates in the US. We believe this is bonkers. By the Fed’s own current predictions short-term rates in the US will be nearing 3% by the end of 2019. This would be very negative for global growth for two obvious reasons:
- Longer-term nominal GDP growth expectations are very low, epitomised by the virtually flat yield curve in the US. If the Fed continues to raise short-term rates, not only will they further drive down longer-term growth expectations, but they will also crush the relative attractiveness of longer-term riskier assets vs. short-term treasuries. As a result, the longer-term investments needed for growth will disappear.
- Rising short-term rates in the US drains liquidity from other short-term lending markets around the world. In other words, rising short-term rates in the US can be transmitted to rising short-term rates everywhere. For instance, in Australia the 3m bank-bill swap rate has spiked over the last year despite the Reserve Bank of Australia keeping their cash rate flat. This has squeezed Australian banks who heavily rely on the interbank market for funding and has led to them passing on this increase in the form of higher mortgage rates in Australia when households can least afford it. In summary, nearly every other part of the world is trying to maintain accommodative monetary policy in response to fragile economic conditions, but this is being undermined by the Federal Reserve who are putting the squeeze on both domestic and international growth. If short-term rates in the US reach 3%, this will be significantly higher than short-term rates anywhere else in the developed world, which will drain significant liquidity out of the system and provide what could be an insurmountable obstacle to growth.
We hope the Fed can appreciate the response of financial markets in October and that their current forecast course for interest rates is far too aggressive. If they acknowledge these facts, then we should see a distinctly more dovish tone which can help to relieve the market volatility we are currently seeing.
Indeed, in the face of similar volatility and stock market turbulence in early 2016, Janet Yellen, the former Federal Reserve Chair acknowledged the situation and reversed her hawkish stance which calmed financial markets.
However, we currently have little confidence that Jay Powell, the current Chair, will follow suit any time soon. As a result, the current market volatility we have seen may continue throughout November and into December. As a result, we currently hold an above-normal level of cash to protect the portfolio in case of further volatility in the short-term. We are closely monitoring the US mid-term elections and the Federal Reserve meetings for potential game-changing events with regards to the path of short-term interest rates and risk appetite and will act accordingly in terms of our cash position if they materialise.
Asides from this, our stock picking process remains unchanged and we were encouraged by strong earnings reports and outlooks in October from many of the companies we hold in the portfolio. Microsoft, Visa, PayPal and Facebook all delivered both good earnings results and bullish predictions for future growth, Adobe provided guidance for 2019 which was better than the market was expecting and Smith and Nephew, a very recent addition to the portfolio, provided an extremely encouraging trading update. Amazon and Google both delivered earnings reports and outlooks which we felt were solid if not spectacular, although both stocks did ultimately get entangled in the deleveraging by market participants during the elevated October volatility. We remain confident in the ability of all the companies in the portfolio, given reasonable economic conditions, to achieve strong growth and profitability in the years ahead.