The testimony from Janet Yellen last week showed that, yet again, the Federal Reserve Bank has blinked amid concerns that the US economy may be entering a soft patch, based on a very recent set of numbers. Long gone are the days when central bank policy was consistently applied using a set of economic principles based on long term economic goals.
As we have said before, equity markets are supported by the knowledge that the guarantor of last resort remains firmly in place with its printing press if need be and will provide liquidity and maintain excessively low interest rates for as long as it can. If they, and other central banks, are truly committed to ‘normalising’ interest rates then they should get on with it and stop being spooked by short-term movements in investment markets and economic data. I accept there is a chance that the US economy is softening a little, as evidenced by the recent inflation numbers being weaker and retail sales softer, but the Fed’s hesitancy should be because there is a real risk of the economy going into reverse, not based on a slight softening.
This in turn is influencing global bond markets as it is unlikely that other central bankers will move independently of the Fed. In the UK, whilst we persist with virtually zero interest rates and the cheapest available finance many of us have ever seen, a debt bubble is quietly building once more. In addition to this, has been the £40bn plus paid out by the banks in the form of PPI claims which average about £3,000 per claim. Many have spent this consumer quantitative easing on a deposit for a car lease, which is doubly attractive with borrowing rates so low. However, we now hear that personal debt is above the level before the Global Financial Crisis and therefore any increase in interest rates will cause all sorts of personal hardship. This very fact is one of the reasons why central bankers are reticent about increasing rates. It is akin to rewarding a spoilt child for bad behaviour just to keep it quiet or failing to scold for fear of rebellion. In the process you create a monster which at some point has to be tackled when it goes off the rails and causes all sorts of carnage. The outcome is inevitable; it is just a question of how long it takes before the problem has to be dealt with and how big it has become when that occurs.
Nothing has changed
It feels like nothing has changed since the various booms and busts of the past and that few lessons have been learnt. Some of this is down to politics and especially now. No person in authority wants to become a pariah delivering unpalatable and unpopular policy regardless of how necessary that may be. This is all more relevant today in this era of populist politicians who will promise anything to the electorate in order to gain power. Emmanuel Macron is currently the poster boy of the EU and even Donald Trump decided to try to share in some of his magic dust by visiting France recently – let’s face it, he needs some as Theresa May is no longer Mrs Popular and could be gone by the end of the year. A ‘special relationship’ with Jeremy Corbyn would be a sight to behold! But it won’t be long before Macron tries to implement some of his reforms, just as Francois Hollande did, and then the lustre on his golden aura will start to tarnish as the spoilt child rebels.
Western consumers and voters have become spoiled and used to living beyond their means, pumped up with debt, which they can only afford whilst interest rates remain on an emergency setting. Historically, inflation would have come to the fore but this hasn’t occurred due to the advent of the internet and consumer power, coupled with the importing of deflation from the east. So now we are in the situation where a small increase in interest rates will send shock waves through the economy as consumers squeal, but they don’t see that the fault lies with themselves. They believe that the problem lies with the banks and the authorities for allowing them to build up their debts in the first place – caveat emptor and mea culpa appear to be absent from today’s personal financial management.
US equities hit new highs
It was no surprise to us that as soon as Janet Yellen announced a softer tone to her interest rate plans that the US equity market hit new highs once more. Everybody is happy because everybody is richer and the punchbowl has just been refilled once more at the debt fuelled party. US national debt is going to breach $20 trillion very soon which is now very similar to annual GDP. This figure was around $10.7 trillion when Obama came to power and $19.6 trillion when he left and he pledged to cut it! Donald Trump makes no bones about his spending plans and some forecasts suggest he will add up to $7 trillion from his policies alone in his first term. When you bear in mind that Obama supposedly tried to balance the books, comparing this to Trump who blatantly plans not to, US debt is set to explode further.
The remit of central banks is limited to the control of inflation as measured by the CPI statistics and ensuring financial stability. However, the CPI statistics do not capture the inflation in the valuations of real assets such as equities and property. Many investors are feeling nervous because so much market wealth has been created over the last few years and those that have taken some investment off the table are the very same crying wolf about valuations – I know this because I have done it myself! Everyone talks their own book.
There are a lot of correction cries now starting to sound hollow as markets continue to defy gravity. We look forward to the US results season with interest which kicks off this week with Alcoa, followed up by the first cut of second quarter GDP on 28th July. Even if there is some softness in the data, there are so few alternatives for the excess liquidity of the typical investor following Quantitative Easing. For now and for the foreseeable future, betting against this market is the same as betting against the Fed – history has shown that investors are unwise to do so but I guess it depends who is in charge, the parent or the spoilt child.
Guy Stephens, technical investment director at Rowan Dartington