Yesterday’s release of the Federal Reserve’s (Fed) minutes offered insights into how Fed decision-makers are thinking about their approach to monetary policy in the current global context. And some of those insights produced spectacular outcomes….You don’t have to look further than the dramatic drop in the equity markets late yesterday to see who is still in charge and why. Whether we like it or not, we still have to pay attention to what the Fed is doing and thinking.
The most important insight in yesterday’s minute release, however, wasn’t the comments about equity market valuations. Like the “Irrational Exuberance” of the tech bubble, as described by former Fed chair Alan Greenspan, this too shall pass. What will not pass quickly is the crystallization of the Fed’s collective view that they have to start unwinding the $4.5 trillion in bonds on the Fed balance sheet at some point this year. While we have heard the message about unwinding from a few committee members, I for one did not believe it was likely to start this year.
This truly is the end of an era. Since the financial crisis, we have been in one long cycle of monetary and liquidity easing. While it has been some time in coming, the reduction of the size of the Fed’s balance sheet would mark the end of the Fed’s rescue mission for the global economy.
Central Bank Intervention Largely Successful
We can debate whether we liked the direction and the magnitude of the economic recovery that followed the Fed’s monetary easing program, but most rational and thoughtful investors, I believe, would agree that the Fed succeeded to a large extent on its mission. If it didn’t, it would be in the same spot as the Bank of Japan and would have remained on a treadmill of ever more intensive easing. Instead, they are talking about unwinding the balance sheet. The European Central Bank (ECB) also succeeded. Despite German resistance, the ECB under President Mario Draghi has also engineered a reversal in Europe’s growth outlook, and is perhaps 18 months behind the Fed in its tightening cycle.
Having said that, success in monetary policy is transient and ethereal, and Maestros become goats in short order.
From a cyclical global economic growth standpoint, the United States is at a relatively good point. Given the stabilization and recovery in the emerging markets, a solid and unmistakable recovery in Europe, and a 2% trend growth rate in the U.S., momentum alone may be enough to enable the global economy to perform reasonably well over the next year or so, irrespective of whether or not President Trump is able to deliver on his policy initiatives.
The modest reflation trade that began midway through 2016 was based on the cyclical strength of the global economy. Markets were likely to do well irrespective of who won the U.S. presidential election. While Trump’s victory was likely to change the fiscal regime and break the U.S. out of its 2% trend growth rate (a shakier prospect right now), we didn’t’ need the change of regime for the cyclical recovery to show through. In other words, markets are not shooting to the next level any time soon, but any corrections would likely be shallow and short, a period of consolidation.
Structural Challenges Remain
From a longer-term perspective, however, the structural challenges for the global economy remain as acute as they were during the financial crisis. While we may not have the prospect of the imminent collapse of the global banking system hanging over our heads, the savings glut out of Asia is bigger than before (it just remains bottled up in Asia itself for the time being); the developed market population is still aging and workforce growth is modest at best; and investment and productivity growth is still not high enough.
In other words, don’t confuse a cyclical recovery and the consequent unwinding of monetary stimulus for resolution of the longer-term structural issues hanging over the global economy. Having said that, as all investors know, we ignore the economic cycle at our own peril.
What is an investor to do with all these musings? In my view, the outlook for global equities is still quite good despite ongoing policy tightening. In light of a lack of Trump-driven regime change, the trend growth rate in the U.S. is unlikely to improve much and, therefore, European and emerging market equities may be better options than U.S. equities. Despite policy tightening in the near to medium term, bonds still have an important role to play in any diversified portfolio.