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Markets Comments August 2016 - Summertime, and the monetary policy is easy

Summertime, and the monetary policy is easy…

The Bank of Japan and the Bank of England have both recently lowered rates. These steps are a continuation of easing policies across the globe but they may also mark the end of central banks easing efforts. With rates negative in most developed countries, central banks monetary policy is now exhausted and has arguably failed in its aim of stoking nominal GDP growth. On the contrary, the longer negative rates persist, the higher the damage to the banks which are the lifeline of the economy. Calls for governments to step in are becoming louder.

Investors are continually having to convince themselves that the current valuations and record-low yields are merited because growth is anemic, deflationary forces abound and rate rises are years away. Still, changing perceptions over monetary and fiscal policy could overwhelm these factors and cause a meaningful and painful rotation within assets.

Base rate rises might be deemed necessary to cause such a shift in investor sentiment and positioning. But even then, as we have seen in the US, a rate rise in the world’s biggest economy has not thus far derailed the unquenchable search for stability and yield.

What do the changes mean for each of the regions?

Japan is at the forefront of this evolution. Fiscal policy was always one of Shinzo Abe’s Three Arrows, but the noteworthy lack of meaningful action from the Bank of Japan in recent months leads to the belief that Japan’s hopes are now pinned on government spending. Governor Haruhiko Kuroda has all but passed the baton back to Prime Minister Abe.

The Bank of England had not changed base rates in seven years, but when it finally moved, it did so with a bang on August 4th. In response to the low growth it expects in the wake of Brexit, it cut rates by a quarter point, to 0.25%, expanded its quantitative easing scheme and introduced a new funding scheme for banks. It will also restart quantitative easing (printing money to buy bonds). It pledged to buy GBP 60 billion in government bonds and up to GBP 10 billion in corporate bonds over the next 18 months. That is on top of the GBP 375 billion of assets already purchased. Both measures are meant to keep credit taps open and provide a lifeline to firms; analysts expect bank lending to companies to contract in coming months. The new funding scheme is designed to help banks and building societies which might otherwise struggle to cut their lending rates in line with base rates. In short, the currency will bear the brunt of the consequences from Brexit.

A bold new program of public investment spending might do more to shore up both business confidence and demand than central-bank bond-buying. The Brexit vote has given Chancellor Philip Hammond carte blanche to ramp up borrowing at record-low interest rates to invest and spend. An early election together with a bigger Tory majority would only increase his boldness. As the government’s spending plans are not expected to change until October, a recession might be under way before fiscal stimulus begins working its way through the economy.

In Europe, Mario Draghi has been calling out for political leaders to do their part on structural reforms and pro-growth policies, with little effect. We are seeing a moderation of the fiscal constraints and penalties that were imposed in recent years to control deficits in the periphery. With elections looming in France and Germany, incumbent governments might decide that they must fight fire with fire against their populist rivals, and fiscal policy must count as a decent bet to win votes. Witness the EUR 360 Billion program over 10 years to rebuild roads in Germany that was announced this week. Fiscal rectitude, while apparently sound, has proven to be politically life threatening.

Monetary and fiscal policies are driving the fundamental movements of the markets. A major shift in either of them will possibly lead to major, long-term shifts in the value of financial assets. Brexit has been a wake-up call for politicians to shift policies or being forced out of office at the next elections. As these trends unfold, we will be happy to guide you through the turbulences ahead. Just drop us line.

Zurich 5th August 2016

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