Andrew Milligan says while changes in central bank communications are bearing on markets, pricing is still rather dovish
In my previous two articles I discussed the cyclical and structural drivers restraining inflation across the major economies. In particular, I warned that markets face a fork in the road, with investors needing to decide whether the transformation of modern economies is re-writing the long standing relationships between inflation, central bank policy-making and financial markets.
The debate about central bank policy-making has evolved slowly into the autumn. Recent European Central Bank minutes showed a central bank wishing to be "patient, persistent and prudent" in terms either of tapering or removing negative interest rates in 2018-19. The Federal Open Market Committee (FOMC) has been very open about its internal debates, with Janet Yellen admitting that recent low inflation in the USA is a "mystery" but not mysterious enough to keep rates unchanged. The Fed's underlying view is that the Phillips Curve may have flattened but wage growth will eventually appear, plus it has concerns about the mis-allocation of capital and financial market excesses. Hence, the probability of an interest rate increase in December has risen towards 80%. Such shifts in central bank communications certainly have an impact on markets - examples would be the recent rally in the US dollar, supported of course by speculation about sizeable tax cuts in the States, or the snap higher in the pound when the Bank of England turned more hawkish.
Even so, market pricing continues to be rather dovish, in terms of low policy rates on a multi-year horizon. At the time of writing, one-month Overnight Index Swap rates for end-2019 are about 1.75% for the US, 0.9% for the UK, and about zero for the euro area and Japan. The median longer-run value of the fed funds rate in the FOMC's latest economic projections is only 2.75%. Such market forecasts imply that today's negative policy rates will persist for years to come. As such, they embody a remarkably negative view about future nominal growth, with considerable implications for future market returns. In the UK, this may become a focus of attention at the November Budget when the Office for Budget Responsibility gives its thoughts on trend productivity and growth in the UK. Some estimates are as low as 1.0-1.5% a year. Other countries are higher such as the US or lower such as Italy but the downward trend is clear across developed and emerging economies.
How do such figures translate into likely returns going forward? One important issue to remember is that GDP growth does not translate easily into corporate earnings growth. For example, operational leverage can alter over the cycle, while in many countries - the UK is a prime example - overseas earnings are of considerable importance so domestic GDP matters less. Another key assumption is that valuations matter over longer time periods. In our latest 10-year returns estimates, for example, on the key assumption of no major recession appearing, then developed market government bonds will probably underperform cash as carry is not enough to offset any duration sell-off. This assumes policy 'normalises' in the sense of returning to higher real policy rates than we have seen since 2008, but still lower than the past 30 years, and that the inflation genie is not let out of the bottle. Similarly, valuations mean real estate does quite well in our estimates but property returns are limited by yield compression having run its course. Finally, equity market multiples are expected to contract in the face of moderately higher bond yields, but this contraction is mitigated as earnings yield spreads to bonds should narrow. In other words, even in a low inflation world buy shares for their corporate earnings potential.
Andrew Milligan is head of global strategy at Standard Life Investments
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