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Features; Fiduciary news

Mind the gap between markets and reality

There is a growing gap between future economic reality and the performance of equity markets. The Federal Reserve needs to signal more of its intentions.

There is a growing gap between the future economic reality worldwide and the performance of equity markets. The Federal Reserve needs to signal more of its intentions.

Charles Stanley

in Features; Fiduciary news


The sharp recovery after the March sell-off has taken US indices to new highs – and provided good gains from the bottom in most other markets. At the same time, figures from the underlying economies have also rallied sharply from the peak of lockdowns, which caused deep and unprecedented downturns in activity in March to May.

The fuel for the market fires has come from all the main central banks. The US tipped the most money onto the flames, but all the other banks cut interest rates, eased controls over banks to allow more credit and bought bonds with newly-created digital money. The rush of extra cash was so strong that it forced a major turnaround in markets at the end of March – and has sustained upwards progress ever since.

With the Fed promising to do whatever it takes to boost asset prices – and keep them higher – investors were able to commit to riskier holdings. Commentators struggled to catch up. They usually settled for explanations based around the speed of recovery from the downturn, with some also hazarding the guess that there would be a quick V-shaped recovery, leaving us without visible damage a couple of quarters later.

This never seemed very likely. Many in the markets latched on to the need for risk but crowded themselves into the digital and green revolution shares, where there could be growth and good news anyway whatever the virus and central banks did next. Apple now has a larger capitalisation than the FTSE 100 in total.

What the Fed failed to say

Last week, we got the Fed's reflections after months of consulting and thinking through its position on how to handle policy in an era of Covid-19 and possible deflation. It was disappointing homework from such an important institution after so much thought. It confined itself to answering the question: How should they handle interest rates in the future? It failed to mention in public what it thought about the size of its balance sheet, the speed and magnitude of money creation and bond buying, and what – if anything – would trigger some wish to reduce the scale of this activity.

This absence was particularly bizarre, as it appears in the most recent month that the Fed has decided to abandon its policy of massive monetary stimulus and revert to low rates of money creation with slower bond buying. It would be good to know why they made this decision, what might change it, and what are the new targets if any for money growth, money creation and monthly bond buying?

These decisions are now the drivers of its policy, and crucial to the future of world markets. We know that when the Fed issues money with abandon – and promises as much as it takes – equity markets race up. How much can they slow this process before markets reappraise? When will commentators want to start highlighting the bad underlying economic news from tourism travel and hospitality about closures and job losses, corporate distress stories from the bond market, and the news of industrial giants forced to slim and reshape to conserve cash?

Rock-bottom rates

The Fed finally killed off the Phillips curve as an inconvenient falsehood. It is sure today that it is nearly flat – so low unemployment does not generate higher inflation nor require hiking interest rates. It reminded us all of its dual mandate, maximum employment as well as 2% inflation. It settled for a much-heralded development of policy that, going forward, it will allow a period of overshoot of the 2% inflation target to make up for the long undershoot in the post banking crash decade. Markets took this to mean lower rates for longer. Does it also mean more cash supply and a bigger balance sheet? That is the more crucial question.

Markets are now discounting a bit more future inflation than at the height of the pandemic downturn, but still below the long-term target as adjusted. The danger is that we might get more inflation from shortages and reduced capacity even whilst wages stay under control owing to the shrinkage of employment. There have been some signs of the asset-price inflation we have seen so far from so much extra money spill over into some commodities. It is probably true that the market thinks this will not prove to be sufficient to warrant a major monetary tightening any time soon.

The best estimate remains low rates for a long time, with more bursts of money creation and bond buying if things slip too much. Central banks are declining to set out any new theory of how they can use their balance sheets and when it might have a stronger impact on real activity. Investors still jostle to buy the shares in companies that are doing well, despite the Covid-19 lockdowns and alarms. The danger is the central banks – with or without warning – will decide they need to normalise their balance sheets more rapidly. That way bear markets lie. It would be good if the Fed would talk to us about what really matters.

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