Central banks – Guiding markets through 2014, Threadneedle’s Waters explains

2014 will generally be a good if not spectacular year for risky assets but is unlikely to be as good as 2013,according to James Waters Client Portfolio Manager –Fixed Income at Threadneedle Investments

We are at another turning point in the economic cycle. After rescuing the
global economy from a monetary implosion and subsequent deflationary
consequences, central banks now have the challenging task of stemming the stimulus in an attempt to cajole economies into a state of self-sufficiency.

How easy is this task going to be? Is the patient hooked on ‘monetary
stimulants’ or is recovery assured? It’s not just the global economy that we need to consider but also the likely path of asset prices. Monetary policy has had a significant effect on the prices of financial assets over the past few years.

As policy changes and the brakes are applied gently (or the throttle closed a little) we need to consider how policy developments could affect these values. There are two effects that we need to focus on here. First, there is the direct impact that is rooted in the monetarist approach.The objective of central banks is to create a stable, low inflationary environment which then provides the foundations for longer-term robust economic growth.

We would like to focus on a more subtle second point, that of confidence and certainty. Through 2008 and early 2009 uncertainty was prevalent across the financial markets and prices reflected that uncertainty. Stabilisation and eventual recovery in markets have been driven not just by the policy actions themselves, but by investors’ belief in the certainty and permanence of those actions, with the expression ‘you can’t fight the central bank’ becoming more and more common.

In the case of the Fed, the largest player in this market, the chosen tool was monetary policy stimulus, conventional and unconventional. The Fed’s message was plain and simple: we will do as much as is needed to resolve the immediate economic issues facing the economy. As the message from other major central banks was the same, a consensus formed.

As the Fed started along the monetary stimulus path, uncertainty was reduced. However, this necessarily excessive monetary policy would naturally inflate something, and in this case it was financial assets. For those investors who understood the story, it was a ‘green light’ to go and buy risk.
Now we are entering a period where stimulus is likely to be withdrawn.

We are at a turning point and there is considerable uncertainty on the timing, magnitude and side effects of this change. Markets in general need a premium for uncertainty. Central banks have started to adopt a policy of forward guidance, attempting to set out the criteria and requirements needed before any tightening or withdrawal of stimulus occurs. The ability of central banks to guide markets through this transformation will be critical.

The key themes in the macro markets in 2014 are likely to revolve around this messaging. This narrative has enormous power to move markets (for example, witness Bernanke’s comments in the early summer, when US Treasury 10-year yields moved up from 1.65% in early May, eventually hitting 3% in September).

Central banks have expanded the arsenal at their disposal since the start of the financial crisis from direct policy rates, through unconventional monetary policy measures all the way through to forward guidance. Forward guidance is, however, the area which is most new for central banks, so if uncertainty is going to be minimised this path has to be navigated with enormous care.

The sensitivity of markets to these messages is huge in itself but it is also exacerbated by the amount of leverage still in the system. As the withdrawal of monetary stimulus gets closer, we expect that central banks are going to have to provide more guidance to investors on the expected path of withdrawal and the factors that are likely to influence this path.

We believe that factors such as employment will fade in importance as others such as wage and price inflation are incorporated into the equation. To ensure credibility central banks will have to balance their narrative. A high-level narrative, such as ‘rates will stay low for as long as it takes for the economy to recover’ will be deemed ineffective, leaving investors with little certainty of future policy rates. But too much detail means that central banks run the risk of losing credibility when they have to backtrack on their own guidance. We have seen the market reaction to the latter in September when the Fed decided not to taper.

We also expect less consistency in the way central banks communicate; we anticipate a trend towards forward guidance but not the synchronised messaging that was apparent immediately after the financial crisis. We continue to believe that policy actions will be the most important drivers of market returns. More specifically, over 2014 we believe that in most cases it will be the narrative from central banks that will be the most important driver of asset price returns, even more than the policy actions themselves. The economy itself is going to be key to this narrative, but markets will look to central banks and their commentary.

We believe that 2014 will generally be a good if not spectacular year for risky assets but is unlikely to be as good as 2013, given current valuations. Global monetary policy stimulus continues, even as the Fed considers tapering. The Bank of Japan has been providing more stimulus through its programme of Quantitative Easing.

Private sector liquidity has also been increasing and is a counterweight to any withdrawal by central banks. Policy risk often represents genuine uncertainty. Beware of markets when they begin pricing in certainty in an uncertain world. The successful fixed income investor in 2014 will need to be nimble, responding yet again to the ongoing tug-of-war between liquidity and uneven growth.

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