Thursday 21 March 2019

Can stock markets keep ignoring global stutter?

Unease: Traders work on the floor of the New York Stock Exchange this week at a time when uncertainty over trade talks is clouding the markets. Photo: Reuters
Unease: Traders work on the floor of the New York Stock Exchange this week at a time when uncertainty over trade talks is clouding the markets. Photo: Reuters
Much of the volatility can be traced back to Fed moves, argues Pat Byrne

Pat Byrne

Global equity markets have soared since the beginning of the year, with double digit percentage gains virtually everywhere.

Indeed from the late December lows, the S&P market index in the US is higher by nearly 20pc so clearly all is well with the world.

Well, not according to the IMF which last month revised lower its global growth forecasts by 0.2pc and 0.1pc to 3.5pc and 3.6pc respectively for this year and next and cited downside risks to its forecast.

In a similar vein, domestic US growth for the final quarter of 2018 could well print below 2pc on an annualised basis when it is released next week, much lower than previous quarters and much lower than previously expected.

Parallel examples are dotted across the globe - from Germany only just having avoided a technical recession to India surprising markets with a rate cut earlier this month to avert downside risks to growth.

So where does the truth lie?

Much of the volatility from Q4, and indeed the outlook going forward, can be traced back to the US central bank, the Federal Reserve.

In December, the Fed raised rates by 25 basis points, taking its target rate to 2.50pc, noting that some further gradual rate increases may be required.

That marked three years and 225 basis points since it embarked on the current hiking cycle. In tandem, the Fed has been sitting on a hugely inflated balance sheet in excess of $4trn - a product of years of quantitative easing - albeit it was being slowly run down through 2018.

Markets have become accustomed to central banks acting as a buffer for volatility and Fed chairman Powell made a mis-step in December through being cavalier towards further balance sheet reductions.

On pronouncing the balance sheet in auto-pilot and that this wasn't likely to change, global markets went into a tailspin.

Equities reacted very poorly to the prospect of reduced liquidity in the system and interest rate markets quickly concluded a policy error from the Fed and began to price in a rate cutting cycle. After an uncomfortable holiday period, the Fed was forced into a major U-turn and since the beginning of this year, the prospect of further rate hikes has been replaced with the need for patience, and a wait and see approach.

The minutes released this week from the end-January meeting cited 'patience' no fewer than 12 times.

Even more remarkably, the minutes further revealed that almost all the members of the Fed now felt it desirable to announce details, in the not too distant future, of its plans to stop reducing its asset holdings.

Next week, chairman Powell will deliver his semi-annual monetary policy report to the US Congress, colloquially, the Humphrey-Hawkins testimony (February 27).

Having miscalculated badly in December, Mr Powell needs to stay on message and to reiterate the need for patience and the intent to pause its balance sheet unwind.

For now, markets are buying into that message.

Equity markets are buoyant, interest rate markets have moved to pricing a largely unchanged rate path and credit markets are increasingly taking comfort from a low volatility environment.

He will likely be pressed on the Fed's own economic projections which include the aggregate member projections of the future path of rates.

Last updated in December, the projections still pointed to a higher interest rate trajectory and are clearly outdated now so the messaging around this needs to be assured ahead of the next set of revisions in March.

Away from the Fed's messaging, a confluence of complicating economic factors lurk on the horizon.

Tight labour markets persist but the impact of the extended government shutdown is still being assessed as is the much reduced domestic fiscal impetus relative to last year.

Of most import, any escalation of the ongoing trade disputes could bring forward the risks outlined by the IMF to global growth.

Those trade negotiations will be keenly watched by the Fed among others but as President Trumps' focus shifts to 2020 electioneering, he will be more aware that the imposition of inflammatory tariffs has the potential to backfire.

The US economic cycle, and by extension the global cycle, is at a delicate point.

The fragility and volatility of markets around the turn of the year demonstrated this.

Interest rates in the US are likely to be unchanged for the foreseeable future and a consistent message on this and the Fed's balance sheet is what is required at this time.

Pat Byrne is head of Money Markets at Bank of Ireland Global Markets

Irish Independent

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