Do central bankers need to toughen up in the face of market fright?

3rd February 2016

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Tom Becket, chief investment officer at Psigma looks at the long-term risks of central bankers’ capitulating to panicked markets…

Just ten days ago there was serious panic in markets and investors were justifiably nervous about the immediate market outlook. Irresponsible nonsense peddled in the media about ‘sell everything’ had whipped up an early year tempest in asset markets.

We outlined a number of reasons why we thought markets were due a relief rally, including the potential for soothing comments from our central banking friends. The last few days have shown how central bankers are totally obsessed with investor sentiment and bewitched by what’s happening in markets. In the short term this could well mean that asset markets go up. In the long term I have to confess to being very worried.

For those of you with more exciting lives than my own, I will paraphrase the comments and actions of central bankers in to digestible nuggets. First, Mario Draghi of the ECB shouted loud and clear ‘come and have a go if you think you’re hard enough’ and made clear that he wants to loosen policy even further at the next ECB meeting in March. Interest rates could be cut down to even more negative territory. Next up, the Federal Reserve last week changed their terminology at their latest meeting where unsurprisingly rates were left unchanged. There was no press conference this time around, but if there had been Yellen would likely have said ‘markets are freaking out, we’re freaking out, won’t somebody please think of the children’.

Markets are now pricing in only one rate hike this year, an outcome far removed from the Fed’s own forecasts that rates would go up four times in 2016. Finally, without wanting to be left out, the hyperactive Kuroda-san at the Bank of Japan ‘surprised’ markets by saying ‘say hello to my little friend’ through the adoption of negative interest rates and loosening policy even further. Surprised? I’ve got to be honest, nothing is surprising anymore. Maybe the only surprise was that they didn’t do this sooner.

Markets took these comments and actions very well, eradicating much of the damage caused earlier in the month. Many credit markets have reversed their losses, whilst equities have won back half the falls suffered during the early year ‘panic’. For that we can be grateful, but there are other things to consider.

The first question we have to ask ourselves is whether this is necessary? Sure, the global economy is growing only moderately and growth will likely fluctuate between solid and sluggish for most of the year ahead. Central bankers have claimed that the threat of deflation dictates that they need to up the ante, but I’m not convinced by this. Certainly inflation expectations have fallen, but core inflation rates are positive and much of the disinflation is due to oil’s influences, which could well reverse in the second half of the year. They might feel the need to boost inflationary pressures, but outside of China’s over-supplied industrial sector, it is not easy to identify genuine deflationary evidence. Therefore we would lay the blame for the latest bout of central bank medicine at the door of markets; equity volatility, widening credit spreads and falling commodity prices have unnerved the masters of the financial universe.

The next thing to consider is the impact upon investment strategy. The fact that Draghi and Kuroda are willing to go to even greater depths to ensure economic and inflationary progress makes one sceptical of government bonds and positive on equities in those regions. In particular, the major rally in Japan over the last two weeks has been welcomed and something we ‘played’ in our strategies. In general, the actions of central bankers should be good for credit investments; income scarcity is going to become more entrenched, credit spreads are extremely wide and central bankers are offering a backstop for markets, at least in the short term. Noticeably other assets we favour, such as gold and REITs (Real Estate Investment Trusts) have enjoyed a major boost in the wake of these latest central bank meetings. The risk now is that increasing currency volatility adds to the already jittery sentiment in global asset markets.

So far, so good. However, there are two final things we need to consider. Firstly and most obviously is the reaction in Beijing. How will China react now that it’s major competitors are so blatantly attempting to weaken their currencies to boost exports? This has to be taken with particular reference to the fact that the Chinese told us last year that the new renminbi rate would be taken on a basket of currencies rather than the dollar alone. It is interesting also to note, given the concerns over Chinese behaviour with their currency, how little weakening they have done when compared with their Euro and Japanese counterparts. If China does truly embark on a period of serious weakening of the currency then we would become much more concerned.

The last point I wanted to raise was a mostly philosophical one. Given that we are obviously not in economic crisis mode and we still have emergency monetary policy being implemented in many major economies and ludicrously low rates in most parts of the world, how do we ever get out of this trap? Many central banks who have tried to raise rates have had to buckle and change course and there is the obvious risk that the Fed, as shown through its recent tremble, cannot get the confidence to implement tighter policy measures. There is also the chance that investors’ faith in central bankers diminishes, which might best be seen through gold’s recent rally. I have long maintained that these events make me much more worried about inflation later this decade than deflation, despite others obsessing more about lower prices. The worry is that ultimately central bankers are too successful in their inflationary aims. This by no coincidence would be very useful with the debt piles that governments find around their necks, which investors are badly positioned for and would cause major damage to certain asset markets.

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