Standard Life Investments

Published Article

Co-ordinating policy


On a day by day basis, asset prices can swing around sharply, especially when all investors are avidly following the same signals from a small group of central bank governors or policy makers. Nevertheless, it is important to understand certain long term trends which ultimately determine the relative performance of financial assets – and the looming risks ahead.

The time horizons for too many investors have sadly become rather short term. This is shown not only in the day to day movements in share prices when reacting to central bank signals, but also the investment vehicles being chosen. A feature of the past year, for example, has been the sharp rise in ETF trading. In many respects this timescale and approach is understandable. Investors prefer flexibility. It does matter enormously whether the Federal Reserve raises interest rates steadily or aggressively into 2017. Hence, the nuanced debate amongst central bank governors over whether the first move would be September or December is important for its signalling effect. High beta assets such as emerging markets will respond accordingly.

We have not been alone, however, in warning that the decisions by central bank governors are becoming ever more extreme, as is their interference in, some might even call it manipulation of, financial markets. A journey of a thousand miles starts with a single step. How far have we come when major central banks are regularly buying or selling currency and government bonds and corporate bonds and equities and REITs?

However, the latest development from the Bank of Japan is potentially a significant stride down this path. One of the dangers of making a series of tactical decisions is that the strategic aim can be lost. The Bank belatedly realised the dangers of moving interest rates into negative territory because of the damage that can cause the banking sector. It had not expected to make QE purchases as large as they eventually became, and warning lights flashed about whether it would run out of bonds to buy. The end result was September's new policy announcement – an unprecedented attempt to control the shape of the whole yield curve from three month rates out to 10 year bonds. Potentially, this may have its own unintended consequences. If benchmark yields in the world's third largest bond market are anchored at zero, encouraging even more Japanese investors to search for assets overseas, how far can bond yields actually rise in other markets? Conversely, if the Fed or ECB ever manage to create a higher level of self-sustaining growth, can the Bank of Japan actually keep yields at zero?

Time horizons also matter because it is increasingly important to understand some of the longer term drivers of financial markets. Central banks and bodies such as the IMF and OECD can help in that sense, through their detailed analysis of the underlying drivers of economic growth and inflation. The key message for investors plainly is – downgrade your expectations. For example, within the 61 pages of the Bank of Japan's comprehensive review of its new monetary policy, there was a small appendix about the trend rate of growth for Japan. The estimates are that it has decelerated steadily to only 0-1% a year. At its latest half yearly review, the Federal Reserve downgraded its medium term growth forecast for the USA to 1.8% a year – in 2010 they had expected over 2.6%a year. A country such as Italy has found it difficult to show any growth for over a decade. The reasons have been well outlined by many researchers: a complicated mixture of demographics, historically low productivity growth, higher regulatory, tax and debt burdens, to name a few. The key point to make is that none of the potential solutions – changes to pension and welfare systems, education and re-skilling - have any quick effect. This is a world of low numbers, with all that means for future asset market returns.

An increasingly strident stream of central bank governors have been warning that monetary tools cannot overcome these deep seated economic problems. A new consensus looks to be forming. One part is clear, the greater use of fiscal policy to support economic activity. Here, the results of the forthcoming US elections look paramount. Under certain circumstances a combination of Democrat and Republican victories and losses could lead to quite sizeable changes in US fiscal policy, potentially opening the door for others to follow suit. Other policies could be used though – the IMF's latest World Economic Outlook report suggested that some countries with entrenched deflationary tendencies could consider the use of an incomes policy in order to provide a strong steer for inflation expectations. We are in a new world where the role of the state is changing, with all that potentially means for asset prices.

How can investors profit from these new trends, or protect themselves from some of the market volatility which these shifts in thinking by policy makers inevitably bring about? One message is still to look for alpha. We should not to fall into the trap of seeing central bank decisions as the sole arbiter of investment decisions, even if we have to accept the fact that a steady lowering of the discount rate through central bank actions in 2016 has inevitably – and in many respects indiscriminately - raised the prices of longer duration assets such as equity and property. October sees the start of the US earnings season, an opportunity for companies to inform investors about their prospects. The focus can turn towards seeing what are mis-priced assets. Valuations do matter, even in this world of low numbers. As the spreads between corporate and sovereign bond fall away, we should beware of default and coupon risks and begin to move into assets with relatively better valuations, say REITS.

At the end of the day, however, we need to use scenario analysis to help with portfolio construction. The central case is clear – that this current situation of low growth, low inflation and low yields continues for some years to come. Imbalances are not yet too worrying – for example high levels of household debt are manageable in most countries as long as interest rates do not rise excessively. Central banks and increasingly governments will use what tools they can to keep growth going, putting up with the unpleasant side effects which are starting to appear. The successful investment style remains looking for sustainable yield, with the emphasis on 'sustainable'. Dividend or coupon cuts would be very painful, as the fear surrounding some European banks clearly shows.

The alternative scenarios are stark. If and when will governments tell central banks to alter their inflation targets, to shock inflation expectations? The debate has begun, notably in Japan and the USA, whether in terms of fiscal policy or even 'helicopter money'. Conversely, when will a recessionary environment appear? When will policy errors, the Chinese debt crisis, the EMU break-up, or some other major trigger, cause a significant slide in growth and corporate earnings prospects? Financial markets are currently priced for an environment where central banks continually try to offset structural trends, not for a dramatic change in either cash flows or inflation expectations.

Andrew Milligan, Head of Global Strategy, Standard Life Investments

First published in Professional Paraplanner, September 2016.