Investors heavily exposed to U.S. stocks just had their best week of the year. But the rebound also raised several questions related to market behavior, policy and economics. How they are answered will prove consequential not only for market prospects but for the global economy. And, notwithstanding the lack of decisive answers at this stage, there are already implications for investment portfolios.
Last week’s strong U.S. equity performance stood in stark contrast to two other market developments.
First, yields on government bonds fell across the board, driving the benchmark 10-year to below 2.10% and that on its German counterpart to minus 26 basis points. The moves are good news for stock investors if they foresee more dovish central bank policies -- but less so if they signal a lower global growth picture.
There is also uncertainty as to the repercussions of such low interest rates. Will they fuel “Japanification” in Europe and, to a lesser extent, the U.S. as households hold back on consumption and worry about shrinking access to long-term financial protection products, while companies hold back on investing? And how deep will the resulting damage be to the longer-term functioning of financial markets?
Another issue is the flood of investor money going into bond funds at such low interest rates. Is it a sign of appropriate, forward-looking risk-management or, instead, a backward-looking, pro-cyclical reaction that increases the vulnerability of investors to future losses?
The second big market anomaly relates to the performance of the higher risk asset classes known as “high beta.” It was notable that, given the sharp rise in U.S. stocks, quite a few of them, including important segments of emerging markets and high-yield corporate bonds, did not rally by as much as would be expected based on historical experience. Was this just a temporary phenomenon or the result of spreading concerns about the global economy?
Turning to policies, there is a disconnect between the cuts now priced in by markets and the consensus justification for such an aggressive policy move by the Federal Reserve.
With the fall in yields, investors are pricing in interest rate cuts of 75-100 basis points over the next two quarters. That goes well beyond anything the Fed has signaled, or is likely to signal in the short-term. An “insurance cut” in interest rates is the most popular market justification for such a further dovish shift by the Fed. That is, rather than reacting to convincing evidence of a significant economic slowdown, the central bank would be building a buffer to counter the effects of trade tensions and weakness elsewhere, particularly in Europe.
Yet the 75-100 basis points priced in by markets goes well beyond an insurance cut, placing the Fed in a lose-lose situation: Either it fails to validate what markets expect or it ends up being forced to react to convincing evidence of a downturn. Neither would encourage market stability.
As I argued last week, the effectiveness of monetary policy is also an issue. The forces holding back growth, here and elsewhere, are not related to financial conditions (that is, the cost of borrowing and the availability of funding). Rather they reflect a series of structural and demand impediments to growth that lie outside the purview of monetary policy.