The pillars of liquidity that have been a core feature of the economic landscape since 2008 are starting to diverge.
Most in focus has been the US Federal Reserve (Fed) and the ‘will-they/won’t-they’ tapering debate.
Less in the headlines but equally important, the European Central Bank (ECB) and Bank of England have notably distanced themselves from any tightening implications with the implicit introduction of forward guidance in order to keep expectations of short-term interest rates lower for longer.
Meanwhile, the Bank of Japan is in a league of its own, with its aggressive bond-buying operations.
The net result: unlike previous episodes since the global financial crisis, central bank policies are starting to diverge and communication is key – a major source of potential volatility.
Emerging markets
The final, and less well-highlighted, pillar is emerging markets. Several emerging market central banks – those of Indonesia, Turkey, India and China – have explicitly or inadvertently tightened funding in their lending markets in recent months.
Most importantly, foreign exchange reserve growth in emerging markets has slowed sharply as competitiveness worsens and capital account surpluses decline.
The recycling of these reserves to prevent currency appreciation has been a major source of liquidity for the world in recent years. The reverse – protecting currencies against a stronger dollar – portends tighter monetary conditions in many of these countries going forward.
US exit strategy
In the US, the Fed has planted the first seeds of an exit strategy from the third round of quantitative easing (QE) against the backdrop of a mixed recovery and a financial market hanging on its every signal.
The manifestation of this is a more volatile US Treasury market. While signs of a recovery are evident in an improving housing and a stabilising manufacturing sector, wage growth remains the missing link.
Additionally, improvement in the US labour market comes with a caveat: the labour force participation rate has also been in decline.
As the Fed tries to balance withdrawal from QE with avoiding a sharp rise in government or mortgage rates, the 6.5 per cent unemployment threshold for tightening will likely become less rigid going forward.
The bottom line is a Fed that has signalled potential withdrawal of liquidity based on a constructive set of economic forecasts through to 2014. But data will be key.
If the economy falls short of the Fed’s forecasts – and this has happened in the past – the lack of inflation in the economy will cap the pace at which the Fed acts.
As central bank policies diverge, so do growth prospects.
Europe stabilising
In Europe, the economy is witnessing a cyclical upturn amid its longer-term structural rebalancing, with manufacturing showing particular strength. The recent ‘mini-crisis’ in the eurozone periphery has shown that contagion risks are significantly lower than this time last year thanks to ECB president Mario Draghi.
For now, potential further easing to help small- and medium-size enterprises and forward guidance for low short-term interest rates by the ECB could support peripheral and European equities.
Year-to-date, developed market equities have witnessed significant inflows – but mostly in US equities. Investors have been systemically underweight in European equities, hence offering upside in terms of repositioning on improvement in economic news. Selective European equities, such as those in Germany and the UK, look attractive due to valuations and growth pick-up.
T
he pillars of liquidity that have been a core feature of the economic landscape since 2008 are starting to diverge.
Most in focus has been the US Federal Reserve (Fed) and the ‘will-they/won’t-they’ tapering debate.
Less in the headlines but equally important, the European Central Bank (ECB) and Bank of England have notably distanced themselves from any tightening implications with the implicit introduction of forward guidance in order to keep expectations of short-term interest rates lower for longer.
Meanwhile, the Bank of Japan is in a league of its own, with its aggressive bond-buying operations.
The net result: unlike previous episodes since the global financial crisis, central bank policies are starting to diverge and communication is key – a major source of potential volatility.
Emerging markets
The final, and less well-highlighted, pillar is emerging markets. Several emerging market central banks – those of Indonesia, Turkey, India and China – have explicitly or inadvertently tightened funding in their lending markets in recent months.
Most importantly, foreign exchange reserve growth in emerging markets has slowed sharply as competitiveness worsens and capital account surpluses decline.
The recycling of these reserves to prevent currency appreciation has been a major source of liquidity for the world in recent years. The reverse – protecting currencies against a stronger dollar – portends tighter monetary conditions in many of these countries going forward.
US exit strategy
In the US, the Fed has planted the first seeds of an exit strategy from the third round of quantitative easing (QE) against the backdrop of a mixed recovery and a financial market hanging on its every signal.
The manifestation of this is a more volatile US Treasury market. While signs of a recovery are evident in an improving housing and a stabilising manufacturing sector, wage growth remains the missing link.
Additionally, improvement in the US labour market comes with a caveat: the labour force participation rate has also been in decline.
As the Fed tries to balance withdrawal from QE with avoiding a sharp rise in government or mortgage rates, the 6.5 per cent unemployment threshold for tightening will likely become less rigid going forward.
The bottom line is a Fed that has signalled potential withdrawal of liquidity based on a constructive set of economic forecasts through to 2014. But data will be key.
If the economy falls short of the Fed’s forecasts – and this has happened in the past – the lack of inflation in the economy will cap the pace at which the Fed acts.
As central bank policies diverge, so do growth prospects.
Europe stabilising
In Europe, the economy is witnessing a cyclical upturn amid its longer-term structural rebalancing, with manufacturing showing particular strength. The recent ‘mini-crisis’ in the eurozone periphery has shown that contagion risks are significantly lower than this time last year thanks to ECB president Mario Draghi.
For now, potential further easing to help small- and medium-size enterprises and forward guidance for low short-term interest rates by the ECB could support peripheral and European equities.
Year-to-date, developed market equities have witnessed significant inflows – but mostly in US equities. Investors have been systemically underweight in European equities, hence offering upside in terms of repositioning on improvement in economic news. Selective European equities, such as those in Germany and the UK, look attractive due to valuations and growth pick-up.
Stephen Cohen is chief investment strategist for BlackRock International Fixed Income and iShares EMEA
