Interesting times ahead for interest rates
“A week is a long time in politics”, as the saying goes. As the UK attempts to navigate its way towards Brexit, 2019 seems to have already lasted for decades in political terms. The parliamentary impasse over the UK’s withdrawal from the EU has already led to Prime Minister Theresa May’s resignation and the succession of Boris Johnson, the third Conservative prime minister since 2016. With the date for the UK’s exit from the EU set for 31st October, the new PM will be short on time to get any deal agreed with Parliament or the EU, meaning that the UK is facing a fresh general election or the prospect of exiting without a deal.Multi-asset funds are becoming increasingly popular among investors seeking to manage risk and protect capital while also targeting growth. Increased volatility, slowing economic growth, geopolitical uncertainty and the worst returns from major asset classes last year since the 2008 financial crisis, have created a heightened awareness of risk and sparked fresh interest in multi-asset investing.
Financial markets have also changed considerably in recent months. By the end of June 2019, the US Federal Reserve chairman was talking about potentially cutting interest rates, which indeed happened in July, and the European Central Bank was promising further financial stimulus in the form of rate cuts or asset purchases, if it felt they were needed. In the UK, the Bank of England kept rates on hold while it tried to navigate the path between the potential need for emergency stimulus in the event of a no-deal Brexit, on the one hand, with the need to curb gradually rising inflation on the other.
But peering back through the mists of time to the middle of 2018, it was a very different picture indeed. By the end of June 2018, the US Fed had just made the second of the four rate rises it oversaw in 2018, and the consensus among investors was for the tightening of interest rates to continue into 2019. US equity markets had recovered from a bout of volatility early in the year and the S&P 500 and NASDAQ were back to setting fresh all-time highs. Employment continued to grow, inflation for 2018 was 1.8%, and US GDP grew by 4% in the year to end June.
The outlook for the global economy was also positive: according to the OECD Global Outlook report from May 2018, the predicted rate of global economic growth was 4% for 2018. And in June of that year, the European Central Bank (ECB) announced it would end its quantitative easing programme of bond buying.
Fast forward 12 months, and the US Federal Reserve has now cut rates by 0.25%, while the ECB is considering both a rate cut and restarting its stimulus programme by once more buying government and corporate bonds in the markets.
WHAT HAS CHANGED THE OUTLOOK SO DRAMATICALLY?
While there have been several significant shifts impacting financial markets, politics undoubtedly has been one of the biggest drivers.
The conflict between the US and China over trade had already begun by early 2018, but by the second half of the year the initial isolated measures, targeted at selected industries, had broadened to cover hundreds of billions of dollars of goods. The last 12 months have also seen an escalation of the trade standoff between the US and the EU.
The volume of trade affected by these tit-for-tat tariff increases is still small in terms of overall global trade, but fears of the knock-on effect have started to be felt in the global economy. The May global economic update from the OECD shows GDP growth for 2019 predicted to drop to 3.2%, as well as becoming more concentrated in areas with less exposure to international trade.
This can be seen particularly in Europe, where the official EU growth projection has dropped to 1.4% for the EU as a whole and 1.2% for the eurozone.
In the UK, Brexit is proving to be a drag on the economy and difficult for policy makers. The initial date for Brexit, 29th March 2019, came and went without any solution to the political standoff, but the uncertainty has seen business confidence drop to its lowest level since 2009. Economic growth remains modest. At its June meeting, the Monetary Policy Committee (MPC) of the Bank of England put GDP growth for the second quarter of the year at zero, down from 0.5% in the first three months of the year, as the short-term boost from Brexit stock piling fades.or years the ‘rule of thumb’ was 60/40 for a core segment of investors (investing 60% in equities and 40% in bonds), the theory being that equities and bonds tend to be affected differently by key events and that an investment portfolio should contain assets whose returns are not perfectly correlated. However, asset allocation within multi-asset funds has moved on significantly from this simple 60/40 split. Many are now complex and it’s important to understand exactly how they are constructed and how their risk/return profile works. Expert asset allocation is at the heart of this, often supported by sophisticated risk modelling and performance profiling tools.
There has been debate recently over changes in the historic correlation between different asset classes, particularly as both bonds and equities declined simultaneously in 2018, limiting diversification benefits from being invested in both asset classes. Long-term studies show, however, that diverse asset classes (not just bonds and equities) rarely perform in identical ways year after year, as factors such as interest rates, inflation or world events tend to impact differently on different asset types. Data on returns from overseas equities, UK equities, UK government bonds, UK property, commodities and cash from 2002 to 2017 show wide variations on a year-by-year basis.
Last year was unusual, as most major asset classes reported negative total returns with the exception of UK gilts, cash and UK commercial property. According to Schroders, 2018 was only the third year since 1900 that returns from the S&P 500 share index and 10-year US Treasuries were negative in the same year3.
OUTLOOK FOR RATES
Members of the MPC voted unanimously to keep the Bank of England base rate at 0.75% at its June meeting. However, it said there is a consensus that “were the economy to develop broadly in line with its May Inflation Report projections that included an assumption of a smooth Brexit, an ongoing tightening of monetary policy over the forecast period, at a gradual pace and to a limited extent, would be appropriate”.
However, it warned its approach would be subject to how the government manages Brexit: “The monetary policy response to Brexit, whatever form it takes, will not be automatic and could be in either direction.”
If the UK appears to be inclined to tighten interest rates, the US and EU are considering a move in the other direction.
The Federal Open Markets Committee, the rate-setting body of the US Fed, cut US interest rates to 0.25% in its July meeting, but said further rate cuts would be dependent on inflation and the strength of the job market. Markets priced in a rate cut in July, but moved lower on comments from Jerome Powell, who implied this cut was a mid-cycle adjustment and not necessarily the start of a new cycle.
The ECB was even clearer about its future intention for interest rates. At its annual symposium in Portugal, ECB chairman Mario Draghi said the bank had considerable headroom to act to increase stimulus for the Eurozone if needed, to counter the rise of protectionism and the drag on European economic growth. Draghi said: “We have our remit, we have our mandate, defined as close but not below 2% inflation in the medium term. We are ready to use all the instruments that are necessary to fulfil this mandate.”
WE HAVE OUR REMIT, WE HAVE OUR MANDATE, DEFINED AS CLOSE BUT NOT BELOW 2% INFLATION IN THE MEDIUM TERM. WE ARE READY TO USE ALL THE INSTRUMENTS THAT ARE NECESSARY TO FULFIL THIS MANDATE.
WHY DOES THIS MATTER TO MARKETS?
In the aftermath of the central bank policy meetings in late June, global equity markets received a further boost, pushing US equities to yet more historic high valuations. Government bonds on both sides of the Atlantic also pushed up, with yields on French 10-year government bonds turning negative for the first time and German Bund yields falling to record lows.(Bond yields move inversely to prices.)
The return of central bank stimulus from the US Fed and the ECB, combined with a delay to any tightening from the Bank of England will mean the supply of cheap money for financial markets will continue, at least for the short term. Almost all central banks, however, have been careful to pledge that any future stimulus is dependent on the circumstances at the time.
With domestic and international politics unfolding at a breakneck pace, central bank policy makers are being forced to adapt to an ever-changing landscape.