The point of maximum policy accommodation may now be in sight
• Markets volatile as investors forced to contemplate U.S. Federal Reserve (Fed) exit strategy.
• Slowing growth in China is putting pressure on Asian and emerging markets to develop domestic led demand.
• This time really could be different for Japan - however reflating the economy was never going to be easy.
The latest U.S. Federal Reserve meeting and the pronouncements of Chairman Ben Bernanke on the future direction of monetary policy have had an immediate impact on financial markets across the world. We still however believe that any rise in official interest rates in the U.S. is still a long way off, perhaps not until 2015, or maybe even 2016.
So the good news is that risks of a return to recession have diminished to the point that policymakers can think about easing off some of the insurance against it. But as the outgoing Governor of the Bank of England put it in his recent speech at Mansion House, “although there are indeed signs that a modest recovery is underway there is still a need to support it”. And recent market moves should not be confused with a return to economic normality, however desirable that might be.
‘Abenomics’ within Japan has provided another demonstration of monetary policies ability to alter the value of financial assets, causing Japanese government bonds, equities and the Japanese yen to fall sharply over the second quarter. In reality, the true economic effects of the unprecedented actions will probably take six to 12 months to be felt. The real test, in our view, will be whether these policies will be able to meet expectations and stimulate demand as well as inflation. Emerging markets suffered outflows in the second quarter in reaction to the U.S. Federal Reserve’s commitment to taper easing measures. Fundamentally, wider Asian and emerging market growth slowed in real and nominal terms at the start of this year, although not all constituent economies’ growth rates have fallen. Indonesia and Brazil, for example, have shown some signs of strength recently, although the overall global climate has led to increasing speculation of easing measures being implemented by central banks. We believe China remains the key driver of growth for the region although weak manufacturing and stresses to its financial system have negatively impacted commodity exporters. We do not see inflation posing a major threat to the economy, given that Chinese policymakers have significant room for maneuver.
Some progress has been made in Europe with the Eurogroup approving the transfer of a tranche of aid to Cyprus. Economic indicators have gradually turned less negative recently suggesting the region may be gradually coming out of recession. Political risk had subsided in Italy after Giorgio Napolitano was eventually re-elected as Italy’s president. Major issues still linger though with harmonized austerity hurting aggregate demand and the final amendments to the single supervisory mechanism yet to be finalized. Recent events in Greece also highlight the ability for things to develop unexpectedly, so we believe a cautious outlook is still warranted.
So while there are encouraging signs economically it is also fair to say some uncertainties remain. In our view, public sector debt issues in the U.S. and Europe are likely to take several years to resolve therefore growth is likely to remain low for some time. A pause at least in risk assets is therefore understandable, especially given the Federal Reserve’s most recent statement and the seemingly inexorable rise of markets so far this year. Fortunately though, investment opportunities do remain. However, we believe a discerning and nimble approach is probably prudent in the near term as markets digest and reflect on the latest news.
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