Short and Sharp: Central banks are not a risk… until they have to be

As we approach year-end, investor thoughts inevitably turn to the risks for next year. Our own internal discussions have identified the following risks: central bank tightening, tight valuations, and politics. While the third is certain to continue festering across many parts of the world, the last few weeks have been encouraging on the first and, in turn, have provided some reassurance about the second.

Perhaps the key piece of news from the central bank front was the appointment of a new Federal Reserve chairman to replace Janet Yellen. As tends to be the case, the run-up to the announcement was more exciting than the decision itself. President Trump’s nomination, Fed Board governor Jerome Powell, should preserve continuity at the Federal Reserve (Fed). As a result, I doubt he will have a decisive impact on the Fed’s near-term policy path and I continue to expect one more hike next month, followed by three or four increases in 2018.

One word of warning though: Markets will likely take some time to familiarize themselves with Powell’s views, and so during this period, the risk of misunderstanding and bouts of volatility will inevitably be higher.

The European Central Bank (ECB) announced that it would extend asset purchases for a further nine months but at half the pace. It was clearly anxious not to unsettle markets, however, managing to avoid the word “tapering” and even re-stating that it would “stand ready to increase” asset purchases. Financial markets took the bait, pushing back their expectations for the ECB’s first rate increase. I expect no change in policy rates until 2019 and doubt the ECB will be a source of much unrest next year.

In fact, the market response to the Bank of England’s (BoE) first hike in 10 years was also very dovish. Gilt yields and sterling fell as markets digested the fact that while the BoE has finally started its 500 mile walk to normalization, Brexit will probably add 500 more. Bringing up the dovish rear was the Bank of Japan as it revised down its near-term inflation forecast.

Central banks have been reassuringly timid in the past month. From where we stand today, dovish central banks will continue to support tight valuations across asset classes. Sure, further capital gains/spread tightening will be more difficult to come by, but without the economy overheating and triggering faster monetary policy normalization, the risks of a significant market correction in the coming months are low.

However, what if the economy receives a positive shock? Say… from tax reform in the United States? Tax cuts would provide the U.S. economy with a boost, and certainly the immediate market impact would be to push U.S. equity markets higher. But then economic and financial overheating could become a real issue – the last few cycles have shown that it is excesses that eventually make the economy vulnerable to a correction.

It is still early days of course. But it is worth keeping in mind that whatever fiscal policy delivers, monetary policy may have to take away…

 

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