The Outlook

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28/06/2017
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A few months on from the supposedly landmark Brexit vote and, from the reaction of the UK equity market, with the FTSE 100 index at the time of writing significantly ahead of its level as at close June 23rd, you could be forgiven for thinking that it was all a bad dream and never happened!

Certainly, the media frenzy now seems to have dissipated somewhat and, although most political parties are in some disarray amidst their particular leadership battles, for now the ruling Conservative party under Theresa May seems to have steadied the ship. And because it was quickly recognised that Brexit did not immediately imply armed guards at UK ports and the banning of all French words from daily use, but would require a long period of tortuous negotiations, markets have quite rightly settled down into more normal operation. Indeed, it was a very positive sign that, with the possible exception of outflows from retail Property funds, markets post Brexit seemed to have behaved in an orderly fashion.

But that, I think, is the charitable interpretation. In the first place, as long as continental Europe put on a brave face and refuse to be infected by Brexit panic, the vote was always going to be a bit of a UK sideshow – there are far more important issues for global markets to deal with, into the medium term, than how we handle this in our own little country. These being, principally, the outlook for US interest rates, the rebalancing of the Chinese economy and financial and banking stability in the Eurozone.

More importantly however financial markets, quite rightly in the short term, immediately jumped to an important conclusion in the few days after the vote. They switched to a view that the Brexit vote, which administered a large dose of additional uncertainty to a world economy already plagued by that affliction, made yet further easing in monetary policy almost inevitable, and not just in the UK. And they were right. The US Federal Reserve did not specifically cite Brexit as a strong reason to keep policy rates stable when it met in July, but unanimously maintained its cautious stance even though domestic conditions in the US economy – unemployment and core inflation – by its own admission, could have justified a tightening. Brexit was the first item the Bank of Japan mentioned when announcing a further major expansion of quantitative easing last month and it was high up the agenda for the European Central Bank as well. Finally, the Bank of England itself, although it did not act immediately, in the opinion of many threw the proverbial kitchen sink at the problem when it restarted quantitative easing in August.

Enormous benefit to sovereign bond markets 

It is this shift in monetary policy which is responsible for the pronounced post-Brexit move of most markets, not just those in the UK. The expectation of further monetary easing has been of enormous benefit to sovereign bond markets. The UK 10 year Gilt traded close to a yield of 0.5% mid-August, but equity markets have rallied strongly as well, a continuation of the recent pattern where bond and equity markets have been positively correlated. Wall Street rose to a new all-time high and emerging markets enjoyed their strongest run this year as the threat of interest rate rises receded.

The danger for investors in all of this is as follows. Insofar as they believe that the future direction of interest rates is down and that they are unlikely to rise again any time soon, then the price of sovereign bonds will rise (and their yields fall) to reflect these expectations. However, the new level of bond yields acts as a floor for other assets too, so we should expect the yields on other, more risky assets to fall too – which to an extent is what they have been doing. However, those assets become more expensive when this happens - the fall in yields we have seen is driving down prospects for future returns, almost stealing tomorrow’s returns today. So it might surprise some people to know that returns from risky assets such as equities and property have been really rather robust since the end of the financial crisis, even though the environment seems to have been strewn with various crises and not at all comfortable from an economic perspective. This merely reflects the fact that current yields and therefore future returns have been driven down as gilt yields themselves have collapsed in the face of quantitative easing efforts that haven’t exactly set the world alight.

Assets Markets unlikely to be as strong as in the past 

We have thought for a while that this is not a great environment for investors – and we haven’t been alone. The McKinsey Global Institute recently published a study of which the major conclusion was that future returns from asset markets were unlikely to be as strong in the future as they were in the past. Unfortunately, this low return environment won’t also be accompanied by lower volatility – so we have the prospect of a prolonged period of low but volatile asset returns, which are more likely as a consequence to be negative.

We are struck as well by the increasing futility of the current policy framework. Although there are plenty more theoretical weapons that central bankers can deploy, we think they are getting to the end of their tether. The Governor of the Bank of England has stated, for example, that he believes that interest rates at the short end of the curve are at, or near their ultimate lower bound because the impact of yet lower rates on bank profitability would make their lowering counterproductive.

Call for fiscal policy 

It looks as if people are finally and belatedly coming round to the realisation that the ‘one trick pony’ of monetary policy easing cannot solve all the worlds’ problems. And this is where I see some reason to be encouraged, for there are some signs that policymakers are coming round to the view that fiscal policy must be brought into the equation.

This has come far too late and is arguably the result of the excessive application of ideology. The belief was that financial market participants would punish heavily indebted borrowers by forcing their bond yields to an unhealthy premium. But if anything the opposite has happened. In Japan, the most indebted sovereign borrower in the world, a huge quantity of sovereign bonds now trade at sub-zero yields. And even if these low yields are the result of purchases driven by the central bank, if anything the cash raised by the banking system from the bonds’ sale is recycled straight back into deposits at the central banks and fails to find its way into the real economy.

With bond yields so low, by contrast, the cost of debt issuance is extremely low. Why not issue more debt and use the proceeds to finance additional spending, preferably on projects which are likely to fulfil an immediate economic need or have an impact upon the wider economy. ‘Shovel ready’ infrastructure projects are an ideal case in point, given the extent to which local authorities have been starved of funds in recent years. Public housing is another.

After all, the best way to reduce the size of the deficit is to get some growth going again to reduce the strain of automatic stabilisers. Policies of this ilk have been notified in Japan in the last few days and by the UK government when it relaxed its 2020 fiscal surplus target (as opposed to imposing, as promised, an immediate austerity budget) post the Brexit vote.

This is a small but potentially profound shift in policy, one that has been advocated for a while by prominent academics such as Larry Summers. It may happen only gradually but it has the potential to have a profound effect upon financial markets – at least enable them to move towards some sort of normality. Otherwise, as Summers has said, we risk continuing in “a world of high volatility, imprudent risk taking, excessive leverage and frequent financial accident.”