In truth, the Federal Reserve’s carefully choreographed announcement on interest rates and the reduction of its balance sheet – inflated to $4.5 trillion by quantitative easing (QE) – was another exercise in controlling the narrative on asset prices. Since the 2013 ‘taper tantrum’, when market volatility spiked in response to the Fed’s earliest curtailing of its asset buying programme, the world’s most influential central bank has been at pains to telegraph policy. Last week, details emerged of the intention to gently reduce the balance sheet by scaling back reinvestment of payments from Treasuries and Mortgage Backed Securities. There was also the strong signal that the Federal Funds Rate would rise by a further 0.25 per cent (from 1.25 to 1.5 per cent) before the end of the year and that there would be further increases in 2018.
On the one hand, Federal Reserve chair, Janet Yellen, was signalling her view that low inflation is due to transitory factors – pointing to tightening in the labour market as proof the economy needs careful stewardship to avoid overheating. Some asset managers, however, look to the fact the Fed has also reduced estimates of its long-term target “neutral” rate, which is where it thinks rates would naturally set themselves without market intervention. Commentators, such as Mark Spitznagel, have pointed out the irony of the Fed moving a target for a number that by definition it doesn’t set. By reducing its inflation forecast (from 3 to 2.8 per cent), however, the Fed was suggesting that it saw limited scope for rapidly increasing rates over the full economic cycle.
This was seized upon by some asset managers as a longer-term dovish outlook that is supportive of equity prices. In other words, the Fed is implying that it will not take action on rates to an extent that would undermine the premium investors earn for investing in riskier assets such as shares.
Political factors will undoubtedly have a big influence on the US, ahead of President Trump returning to Congress in an attempt push through his tax reform stimulus. Of direct significance for Fed policy is Mr Trump’s potential to nominate new members for the Fed’s Open Market Committee. The interplay between any fiscal stimulus and the potential for more hawkish monetary policy will be paramount for US and global markets in 2018.
Political concerns are even more prominent for Mario Draghi at the European Central Bank (ECB). In theory the ECB is politically independent. Yet in practice it faces an almost impossible balancing act juggling the sometimes disparate monetary policy needs of several major economies in the eurozone. The task cannot have been helped by Germany's recent election result. While the spectacular performance of the Alternative for Germany was built on a platform of scepticism towards chancellor Angela Merkel’s open door policies during the 2015-6 refugee crisis, she is now faced with building a troublesome coalition. Potential partners for Ms Merkel’s Christian Democrats have been scathing about the ECB’s bond-buying programme, so Mr Draghi may feel the pressure to taper sooner rather than later. The problem is whether this is necessarily in the interests of other parts of the eurozone. Notably in France, accommodative monetary policy would be a boon to president Macron as he seeks to introduce economic reforms. More broadly, tapering too rapidly could derail the positive narrative for the eurozone, which as well as buoying European bourses, has emboldened the EU’s Brexit negotiators.
Some commentators see the unwinding of QE as an opportunity to make tactical asset allocations to take advantage of an upturn for the investments which underperformed in recent years. Jan Dehn, head of emerging markets research at Ashmore, views the unwinding of QE as an opportunity for emerging markets. He says: “The main QE trades of the past several years – long US stocks and European bonds will begin to reverse, and the most profitable trade is likely to be to take profits from QE markets and go long the non-QE markets.” In other words, there could be an opportunity to profit from emerging markets where asset prices were depressed by the flight to QE markets.
There is a cautionary note, however. Japanese prime minister Abe’s announcement of a snap election threatens the possibility of a change in policy mix and may result in the Bank of Japan (BoJ) taking more relative responsibility for economic stimulus. If the BoJ continues with hard stimulus at the same time the Fed is tightening, there are potential ramifications for currency markets. Investors in emerging markets should be well aware of the need to watch the value of the US dollar against other major currencies. As 2018 approaches, investors will need to keep an eye on global political developments, too.
