As we enter the second half of 2016, market sentiment has been fluctuating in the wake of British voters' decision to leave the European Union, weak economic data and the decision by many central banks to take a pause from monetary easing. It seems that our guidance in January 2016 has very gone as predicted.
Some thoughts for the balance of 2016:
The immediate reaction was surprise that the UK voted to leave the EU. But after a while it was like Brexit never happened. There were two main reasons for investors' renewed confidence: An expectation that because of the initial volatility sparked by Brexit, central banks would ease interest rates further and a growing realisation that Brexit was a 'containable' event that might hurt the UK economy but won't have that much spillover or contagion elsewhere. So the effect on the global economy wouldn't be as bad as people had feared. But then things changed. Central banks started to disappoint investors by keeping rates on hold and some lack lustre economic data started to appear. Second-quarter GDP in the US wasn't as strong as expected, Chinese data showed some weakness and oil prices slumped below $40 a barrel.
Put all this together and you can see why in the weeks following the Brexit vote market sentiment was swinging so much.
Low Rates & Monetary Policy
There's no doubt about the commitment of central banks to provide a cushion in the form of easing interest rates. But the question is whether policy makers are running out of monetary policy ammunition. We believe central banks are likely to become increasingly prudent about additional monetary easing due to the diminishing benefits.
The recent 25 bps decrease by our RBA only saw on average 10bps passed on to borrowers reflects this.
Indeed, we've already seen that with quantitative easing. The first round of QE was impactful but then with the second and third rounds the impact was smaller and smaller. Let's look at what's been happening in Japan, where negative interest rates have affected banks' profitability, which in turn has affected their ability to provide credit. The market clearly expects the Bank of Japan to ease monetary policy still further. If it doesn't meet expectations, the market will be disappointed and monetary conditions will be significantly tightened as the Yen appreciates. But if it does meet or exceed expectations, the market will soon realise that the more aggressive the Bank of Japan is, the faster it will run out of assets to buy. So the Bank of Japan is in a dilemma. Either it has to find a way to make their monetary policy more sustainable or it has to think outside the box.
Governments turning to Fiscal Policy?
People always say that increased government spending has a kind of 'crowding out' effect—when government invests more, that drives up interest rates and discourages private sector investment. But with global interest rates stuck at very low levels, this limits the downside of fiscal policy and makes it potentially much more effective. We think fiscal policy can be more effective and can play a bigger role in this kind of situation. And that's exactly what Japan and China are doing. Increased fiscal stimulus and infrastructure spending are creating real demand to boost economic growth in the near term. But fiscal stimulus isn't a game changer and won't have any long-term effect on the real economy if it's not accompanied by structural reform.
Traditional levers such as monetary and fiscal policy only buy you time to push forward the necessary but painful structural reforms that can really boost productivity and potential long-term economic growth.
Speed bumps Ahead!
Looking further ahead this year, the US elections are likely to generate an increasing amount of noise that will affect market sentiment. But if people ask us what's the biggest risk down the road I would say global inequality. Globalisation has generated unprecedented levels of growth and prosperity over the past few decades. But now we're beginning to see the beginnings of a backlash from voters in developed countries. While capital can move freely from countries like the US to cheaper economies like China, people cannot move so easily. The challenge for policymakers around the world is to ensure the benefits of globalisation are spread more evenly.
Our advice to You
Our advice to investors is don't panic! Don't be too bullish as the global economy continues to muddle through in the midst of deleveraging pressure and structural deceleration. But equally we wouldn't be too bearish as there's limited downside risk with central banks providing a cushion. The Bank of England has led the way by cutting rates to 0.25% in early August, with further cuts likely to come. Other central banks may be on hold at the moment but we believe the Bank of Japan and the European Central Bank will ease rates later this year. And our revised position is that we might only see one more rate hike from the US Federal Reserve in 2016. While US economic growth was only 1.2% for the second quarter, that was largely because of inventory correction. So we do expect the US economy to pick up in the second half of 2016. Meanwhile in China, the government's continuing support for infrastructure investment should ensure the slowdown will be gradual.
So the best plan forward is stick to the basics—set clear goals, keep portfolios diversified, keep costs low and stick to your long-term plans.
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