The limits of monetary policy
The US-China trade dispute and renewed monetary policy easing have been the main market drivers this year.
The trade conflict still has the power to drive markets, and progress toward a Phase One trade deal helped propel US stocks to a record high last week. But while the Federal Reserve cut rates last week, we think monetary policy is less likely to drive equity market direction in the months ahead:
The Fed has sent a message that it is now on hold.
- It has lowered rates for the third time since July, cutting the federal funds target range to 1.5%–1.75%, but changes to the FOMC’s statement and Chair Jay Powell’s press conference suggest the Fed would only change policy if there were a "material reassessment" of the economic outlook.
The ECB is likely to be less radical under its new president, Christine Lagarde.
- While Lagarde's previous statements suggest she is just as dovish as Draghi – she said in August that ECB policymakers must be ready to act to protect the economy – she is also considered a consensus builder. And, although the ECB has committed to quantitative easing, dissent is growing among more hawkish ECB policymakers. French central bank president Francois Villeroy de Galhau said that he was "not in favor of the resumption of net asset purchases at this time," considering it "unnecessary." The Bundesbank's Jens Weidmann suggested that Draghi had "overstepped the mark" at a time when the "economic situation is not all that bad."
Meanwhile, the Bank of Japan is also on hold.
- Last week, the BoJ left its policy rate at -0.1%, where it has been since January 2016. The BOJ suggested it might consider further easing, but only in response to deterioration in the economic and market outlook.
Central banks are also facing visible limits to the effectiveness of their current policy.
- The tiering of rates in Europe is a sign that the ECB has had to innovate to mitigate the adverse consequences of negative rates. The Riksbank's Stefan Ingves has said that the risks of negative rates would increase if the policy became entrenched, and he plans to put an end to negative rates despite continued signs of economic weakness. China has had to introduce a new loan prime rate benchmark to try to improve an inefficient monetary transmission mechanism that has failed to meaningfully lower corporate funding costs despite sufficient bank liquidity. And in Japan, despite the negative rate policy since 2016, banks maintain their cautious attitude toward lending.
With monetary policy unlikely to set the market direction from here, stocks will probably take direction from trade and economic data. Optimism on trade is already high, but the economic picture is sluggish.
Given how strong markets have been this year, we are focusing on earning yield rather than looking for higher equity prices. We maintain a modest overall underweight to equities with a preference for US and Japanese equities relative to Eurozone stocks, which reflects our view on the relative earnings outlook. We prefer USD-denominated sovereign bonds to stocks in emerging markets, and we overweight select high-yielding emerging market currencies versus a set of lower-yielding currencies in our FX strategy. We also continue to recommend an overweight to US Treasury Inflation-Protected Securities (TIPS), which should outperform US government bonds as markets begin to price in higher inflation expectations.
Bottom line
The Fed has cut rates three times since July, but has now signaled that it is on hold. The ECB is likely to be less radical under its new president, Christine Lagarde, and the Bank of Japan is also on hold. Meanwhile, the effectiveness of monetary policy appears to be reaching its limits. Against this backdrop, monetary policy is unlikely to set the market direction from here. We continue to focus on earnings yield rather than looking for higher equity prices.
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