A couple of weeks ago, Citi’s Matt King discussed what is perhaps the best reason of all to be cautious about dipping your toe into equity markets that are trading at elevated (and that’s putting it very, very nicely) multiples and/or into credit markets where spreads have compressed massively from wides seen 12 months ago.
For those who missed it, here is King’s simple question for those inclined to go (or “stay”) long:
Do you really want to be buying credit at post-crisis tights, or the S&P at a cyclically-adjusted P/E which has been exceeded only in 1998-2000 and 1929?
That’s obviously a rhetorical question. The answer is “no,” you do not.
But that hasn’t stopped folks from piling in and as I’ve been pretty keen on reminding the retail crowd: the central bank liquidity flow backstop is on its way out the door, albeit slowly. Here’s what I said last week on this:
If you’ve looked into the situation enough to understand the concept of central bank QE “flow” providing a near constant bid for risk, then you’ve almost surely come across an article (or six) explaining that the monetary powers that be are currently plotting their exit. Armed with that knowledge, you’d be unlikely to buy into a market that Goldman recently described as follows:
- After the inflation in P/E multiple, the S&P 500 now trades at the 90th percentile of historical valuation relative to the past 40 years. Current consensus forward P/E of 18.1x is the highest level since 1976 outside of the Tech bubble. The median stock trades at the 99th percentile vs. history.
For the visual learners, here’s what the central bank put looks like (and remember, it’s the “flow” that matters, not the “stock”):
(Citi)
Of course trying to keep track of where each central bank (i.e. the Fed, the ECB, the BoJ, etc.) stands when it comes to normalizing policy is quite difficult. Unfortunately, it’s necessary. And not only because you want to know when the proverbial punch bowl is going to be taken away. You also need to be aware of the extent to which mismatches in the timing of normalization create policy divergence, drive rate differentials, and influence FX markets.
So given all of this (and that introduction turned out to be a whole helluva lot longer than I meant for it to be, so sorry about that), I thought you might find the following graphic from Barclays interesting. Now keep in mind, policy is obviously not on a preset course, so all we have are guesses, but in this visual, Barclays attempts to illustrate their projections for policy normalization across central banks and if nothing else, it should serve as a kind of calibration tool for your own expectations with regard to the preservation or disappearance of the central bank put.
Via Barclays
Fed: A more confident FOMC leads the way In contrast to 2015 and 2016, when economic developments at home and abroad thwarted the Fed’s plans for a four-hike pace in the coming year, 2017 has started out differently: the Fed now faces decent US growth, supported by buoyant sentiment, easier financial market conditions and no complications from ‘international developments’. This has given the FOMC more confidence to finally implement its game plan of a gradual hiking cycle; we now expect it to hike two more times in 2017 (Sep and Dec) and three times in 2018 at a pace of 25bp each time. A hike this June — not our baseline — would suggest a faster pace of four hikes per year, in our view.
Along with this firmer tightening cycle, we also expect the Fed to begin earnest discussions over when and in what manner to reduce the size of its balance sheet. Even so, we continue to believe that the Fed is far from taking any concrete action and we expect its balance sheet to remain substantively unchanged through at least the end of 2018.
ECB: complicated normalization ahead. Better growth and the rebound in inflation has significantly improved the balance of risks for the ECB by reducing the threat of a deflationary ‘Japan’ scenario for the euro area. However, the euro area is still far away from comfortable self-sustaining inflationary dynamics, and it still faces the looming risks associated with fragile public debt dynamics. The latter is particularly sensitive with regard to the euro area’s third largest economy and world’s third largest debt market, Italy, where there still appears a lack of political resolve for reform and uncertainty about the political outlook remains high. While this calls for caution, above-target headline inflation in Germany and the adverse effects of negative deposit rates on financial institutions are creating pressure on the ECB to start normalizing monetary policy.
In an attempt to balance these factors, we expect the ECB to implement a mixed strategy:
We first expect in June (after the French presidential election) a change towards less dovish forward guidance that would open the door for deposit rate hikes in 2018, even before QE ends.
- We then expect a reduction in QE to EUR35-40bn per month in H1 18 and EUR15-20bn H2 18 as well as two 10bp hikes in the deposit rate in Q2 18 and Q4 18. We assign low probability to rate hikes in 2017 and PSPP purchases to stop in early 2018. In other words, we expect both QE and negative deposit rates to remain in place until at least H2 2018, even if at less-accommodative levels than in 2017.
- This would clearly be a significant shift from earlier communication that suggested rate hikes would only follow once the asset purchase program had been terminated — which was the sequence the Fed and BoE used. Of course, neither the Fed nor BoE ventured into negative policy rates or had to implement QE across a diverse sovereign debt market. Such a multipronged exit strategy by the ECB would present a delicate communications act, as markets would have to decipher the net effects of a simultaneous tightening via deposit rate hikes and continuing expansion via asset purchases, even if at a reduced pace. Given the risk of adverse shocks (on inflation or debt dynamics) and memories of past episodes of premature tightening, we expect the ECB to move cautiously.
BoJ: ready to follow. The BoJ stood pat in March, as widely expected, and did not provide any hints of a future move or change in related communications. However, as the global environment remains supportive, we expect the BoJ to:
- raise its YCC target for long-term yields (+0%) by 10-20bp in Q3 17, assuming y/y core CPI inflation is accelerating at that stage, and
- hike a further 20bp each in Q1 18 (prior to the end of BoJ Governor Kuroda’s term in April 2018) and in Q3 18, due in part to a tailwind from expected continuing rate hikes by the Fed and, indeed, the start of an exit strategy by the ECB (hike in the deposit facility rate/reduction in asset purchases).
This will leave the BoJ in a reactive position as its yield-targeting policy since September has allowed it to ‘import’ passively the tightening in the US and other core markets. Overall, our inflation forecasts suggest that while the BoJ may have overcome deflation, the 2% target — which it promises to overshoot — is still not on the horizon.
BoE: still sitting on the fence. Surprisingly resilient data have made the BoE more confident about the economic outlook. March meeting minutes reported some members moving closer to supporting a hike, with MPC Forbes (outgoing in June) even voting for an immediate hike. However, we expect the rest of the MPC, in particular Governor Carney, to move more cautiously, waiting for data to crystallize before considering adjusting its monetary policy stance. Given our expectation for a slowing economy and only a temporary FX-driven boost in inflation, the MPC will most likely remain on hold over the forecast horizon, while markets have started to price some probability of a hike in 2018.
