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Update: Change Of Tack

By beled | February 5, 2019

Extract from the December 2018 quarterly report:

A feature of the past quarter was the sudden capitulation of global economic growth expectations and sharp downward corrections in economically sensitive asset prices such as shares and oil. The dominant force at play appears to have been US monetary policy which became excessively tight relative to prospective growth and inflation but ongoing tariff wars no doubt played a role too. Tighter US monetary policy (chart 1) was a consequence of the Fed’s oft-stated intention to normalise the term structure of US interest rates (known as the “yield curve”). Aggressive quantitative easing (QE) following the global financial crisis of 2008 created downward distortions in interest rates, especially short-term rates (chart 2):

Chart 1: US Federal Reserve Credit extended to the US Banking System, $bn

Chart 2: Short (3m) and longer term (10yr) US interest rates (%)

In order to achieve the higher target interest rates the Fed switched from not supplying any new liquidity (2015-2018) to actually removing liquidity from the banking system from early 2018, i.e. from chart 1 it can be seen that the Fed changed from being non-accommodative to restrictive approximately 12 months ago. With short-term rates rising faster than longer-term rates, the yield curve has come close to inverting (short rates higher than longer rates, chart 3). In the past this situation has usually led to recession within 6-18 months* so the recent reversal in growth expectations, asset and commodity prices is understandable.

*The Yield Curve as a Predictor of U.S. Recessions, Arturo Estrella and Frederic S. Mishkin, Federal Reserve Bank of New York, Current Issues in Economics and Finance, June 1996, Volume 2 Number 7.

Chart 3: Yield curve inversion, % (US 3 month TB – US 10 year Government Bond)

We believe that the Fed is acutely aware of the above and both slowing economic and inflation data support chairman Powell’s recent conciliatory comments regarding further interest rate increases. While there is no guarantee that they will not do anything “crazy” (Trump’s opinion of recent Fed policy), the most likely scenario is a return to a less restrictive monetary policy stance and even to QE if growth slows dramatically. On the fiscal side some sort of trade deal with China seems likely, as is fairer cost-sharing with NATO. On balance we believe investment fundamentals could improve in 2019 after the setbacks of 2018.

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