Finding equilibrium: a return to 'normal'?

February 13, 2019 14:34
Countries and companies in the region have built up a significant US dollar debt that becomes more expensive to pay back as the US dollar rises on higher rates. Photo: Reuters

In 2019 we will be looking to see whether global markets can move to a new equilibrium, balancing an acceptance of higher interest rates and the draining of extraordinary liquidity against what we believe are decent prospects for steady, if unspectacular, global economic growth.

If the last four months of 2018 are anything to go by, expect a bumpy ride.

For the last 10 years, central banks have supported markets by keeping interest rates at historic lows, and by using quantitative easing to pump around US$15 trillion into the global economy to boost growth after the financial crisis of 2007-08.

These measures have led to a significant distortion in asset prices: in the fixed income market alone, we now have some US$$8.5 trillion of government bonds with 27.5 percent of eurozone bonds currently trading with a negative yield – in other words, investors are paying to own them.

Central banks, led by the US Federal Reserve, know such a situation cannot be sustainable in the long term; indeed, this had always been termed an “unconventional” policy. If rates have been rising over the past two years, it’s because the Federal Reserve believes, as we do, that global economic growth has strengthened enough to be able to cope with higher borrowing costs.

Clearly, the transition has been difficult with market volatility and most asset classes outside cash posting negative returns year to date. Emerging markets have been particularly hard-hit. Countries and companies in the region have built up a significant US dollar debt that becomes more expensive to pay back as the US dollar rises on higher rates.

The questions is: will markets eventually learn to adjust to higher rates if economic growth continues to hold up? Or is the global economy still structurally compromised whereby any move towards a more normal interest rate environment becomes self-defeating?

In some sense, the Federal Reserve answered this question with an apparent about-turn in January this year, pulling back from the idea that balance-sheet contraction was on "auto-pilot" and stressing instead the need for patience and the close examination of all future data to determine how next to proceed.

The market responded with one of the strongest January equity rallies on record. We believe that the change of tone represents more a pause in policy rather than a signal that the period of expansion in the US economy is coming to an end, and interest rate cuts are on the way.

In this environment, we expect the market to remain volatile. We choose to keep invested in yield-oriented assets such as US and EU corporate credit where we have visibility on income streams. We do retain selective exposure to developed equity markets.

An area where we have upgraded our assessment post the year-end is exposure to emerging and Asian equity markets. A more pragmatic Fed, policy changes from the People's Bank of China, and a valuation cushion have tempted us to dip our toes into the region.

However, we have not become unabashed bulls. We work hard on diversification and retain a nimble approach.

– Contact us at [email protected]


Head of Strategy, Multi-Asset at Jupiter Asset Management