ECM’s Henrietta Pacquement sees fine line for central bankers to walk
Henrietta Pacquement, lead portfolio manager at ECM Asset Management, says that despite record levels of central bank supported liquidity at a global level, those responsible for monetary policy still must tread a fine line when communicating their intentions to the market.
Markets are still high on central bank liquidity with some $10trn worth of assets now held by the major developed world central banks (see graphs below). The Federal Reserve (Fed) holds close to 40% of these assets and is still adding to its hoard. The Bank of Japan is busily adding to its balance sheet supporting the Abenomics experiment.
In contrast, Europe is showing some restraint. The Bank of England’s assets have stabilised around £400bn and the European Central Bank (ECB) has even shrunk its asset pile by some 25% since the peak in 2012. The ECB however is still being extremely generous in words promising an additional Longer Term Refinancing Operation (LTRO) if liquidity is called into question and the Outright Monetary Transactions (OMT) mechanism is still an open commitment by Mr Draghi. This considerable largess continues to support asset prices despite politicians’ best efforts, be it in Italy or the US to scupper the modest growth prospects ahead.
Interestingly, the International Monetary Fund published its quarterly global financial stability report summarising its view of the world. Their conditions and risk map (see below) is a good summary of the strains currently in the system and their evolution since April, prior to the tapering announcement of the Fed.
Overall, globally, risks have modestly increased since the spring and that has translated into a modest retrenchment of risk appetite. Growth prospects remain subdued with risks skewed to the downside. Emerging markets are under pressure from a growth perspective and face the prospect credit tightening at an unfavourable time in the cycle.
Credit risks remain above average as the European banking system is still in repair mode having lagged its US and UK counterparts. Market liquidity risks have edged up following the tapering announcement and the prospect of less asset price support. However, monetary and financial conditions remain generally accommodative and risk appetite above average though slightly weaker following increased caution around emerging markets.
How has that translated into asset price volatility?
The increase in risks has translated into a jump in volatility levels across asset classes particularly hitting sovereign bonds in the US, bonds and currencies generally in emerging markets and equities and currency in Japan. All these assets classes have seen their recent volatility spike above the average we have seen post the financial crisis and in the case of emerging market bonds considerably. In contrast, Europe has been reasonably sheltered.
Going forward what is most needed in developed countries is growth, particularly in Europe and especially in the periphery.
Currently growth indicators continue to progress. PMIs are improving, as are confidence levels, bank lending surveys (in particular for consumer loans) and credit markets continue to show a degree of compression between core and periphery. Target 2 balances are reducing. Periphery competitiveness is improving and this is translating into better export numbers. In theory, fiscal pressures should be reducing given the efforts already made. But capital expenditure levels remain low, earning revisions are still mixed and industrial production numbers remain hit and miss with disappointing numbers out of the UK, France and Italy.
As touched on above, the European banking system remains in repair mode with pressures still coming from non-performing loans (NPLs). This remains particularly true in Southern Europe. But leverage levels are coming down, loan to deposit levels are trending lower and the asset quality review (AQR) in months to come is an opportunity not to be missed to further banking sector repair in Europe.
True, debt levels remain elevated justifying the unprecedented amount of central bank liquidity. Questions about debt sustainability remain in borderline countries such as Greece or Portugal. Austerity fatigue and temptations to support the far right of the political spectrum are high. The Tea Party has enough support to breakdown the normal course of democracy in the US. Recent polls in France on the European elections are showing the “Front National” up at 24% of voters’ intentions. Imbalances in emerging markets are also likely to continue to be highlighted as developed economies recover.
However, asset classes benefiting from positive GDP trends are likely to see their valuations continue to be supported; this includes credit spreads and equities. Rates on the other hand are under pressure in this context as we edge towards normalisation of monetary conditions.
Given the European banking system is still repairing and valuations reflect this. European financials is a sector of particular interest at the moment. However, be under no illusion, the system is still supported by $10trn of liquidity. This leaves plenty of risk for policy mistakes. As market reactions to tapering talk since May show, it will take deft communication from central banks on their intentions to ensure the process is as smooth as can possibly be expected. Central bankers will also need to compose with political time that continues to have the propensity to slow structural reform progress and thereby growth prospects. But we see market weakness going forward as opportunity to add risk.