Monetary Policy and the Dilemma Facing Central Banks
By Percival Stanion, Chairman, Strategic Policy Group
Baring Asset Management (Barings), London
(Barings is the Subadviser to the ASTON/Barings International Fund)
Interest rates could rise “sooner than the markets expect,” said Mark Carney, Governor of the Bank of England (BoE) in June. His statement and the hasty retreat in the following days illustrate the dilemma facing central bankers across the developed world. On the one hand, they want to manage market expectations for an eventual end to today’s ultra-easy monetary policy. On the other, real economy data for many markets is still sufficiently weak as to deter raising interest rates. Across the developed world, each central bank has a subtly different communication problem to overcome, but they all need to be sensitive not to undermine their own credibility.
In the U.S., harsh winter weather has amplified the confusion. First quarter Gross Domestic Product (GDP) was recently revised down to -2.9%, which will inevitably lower the overall growth rate for 2014. In our view, catch-up spending in the second quarter could boost the data, even though it is likely to ease back again during the second half of the year. We expect inflationary pressures to remain relatively modest, in-line with this slower economic activity. We believe the US Federal Reserve’s preference will be for interest rates to remain on hold until well into 2015. Their dual mandate, to promote both growth and full employment, obliges policymakers to help foster conditions favorable to job creation. Although there has been robust job growth recently, there remains a considerable number of long-term unemployed people. Notwithstanding this, events such as sharply falling unemployment or a surge in inflation could make them act sooner, or risk a major loss of credibility.
In the UK, meanwhile, Mr. Carney has undermined his own forward guidance policy by suggesting the possibility of an earlier increase in interest rates. This may have shaken out overleveraged positions, but Mr. Carney now has to be careful not to impair his credibility with the markets. Early data that shows the impact of tighter underwriting standards on mortgage applications seems to indicate the market has meaningfully softened. This may be sufficient to slow the UK’s economic growth rate from the recently recorded 3% and delay the first rise in interest rates until next year. In our view, if the data remains strong due to continued jobs growth and rising wages, the BoE will have to act or risk a major loss of confidence.
Within the eurozone, Mario Draghi is successfully transforming the European Central Bank into a more pragmatic institution by remaining engaged in a continuous dialogue with markets. The recovery in Europe is progressing and GDP may hit 1.5% this year. Deflationary forces are still powerful, however, especially in the weaker peripheral countries. Therefore, Mr. Draghi put forward a package of measures that aim to counter this trend and, in particular, address the issue of high credit costs for small- and medium-sized companies in the south. Markets have taken most of Mr. Draghi’s initiatives on faith so far, but he may face a sterner test now that a tangible program will soon begin.
Standing back from the detail, global monetary policy still seems very supportive of economic growth, which supports our view in overweighting equities. We have to acknowledge, however, that market valuations have seen a huge rise in the past 18 months. While the outlook for corporate profits is for modest growth, it appears difficult to justify another leap in valuations. So progress for equities could be slow, even if equities remain ahead of other asset classes. Within global equities, we favor Japan, which we believe still may surprise a skeptical investor base. The market is attractively valued compared to its peers and earnings growth expectations are well underpinned. Elsewhere, we have upgraded our view of Emerging Markets to neutral. The long-term story is still compelling compared to the West and valuations are now reasonable. We have downgraded continental European equities as the fragility of the banking system and the strains of the new Basel III rules could threaten to de-rail Mr. Draghi’s initiatives.
The information contained in this article is provided by Baring Asset Management (“Barings”), a subadviser engaged by Aston Asset Management, LLC (“Aston”). Barings is not an affiliate of Aston and their views do not necessarily reflect those of Aston.
This material is not intended to be a forecast of future events, does not constitute investment advice, and is not intended as a recommendation to buy or sell any security. Investors should consult their investment professional regarding their individual investment program. Since the date of this report, economic factors, market conditions and Barings’ views of the prospects of any particular investment may have changed. Investors should consider the investment objectives, risks and associated costs carefully before investing. Forward-looking information is subject to certain risk, trends, and uncertainties that could cause actual results to differ materially from those predicted. Past performance is no guarantee of future results.