Another dovish central bank and another strong US employment report, and investors are tripping over themselves to increase risk in their portfolios. With many now also focusing on holidays, the next few weeks are likely to be deadly dull, although we cannot rule out a risk off event entirely. Lots to think about in the big picture and we’ll start with the US.

The monthly jobs report in the US showed a robust 255,000 new jobs created as per the establishment survey. This exceeded expectations, following on the heels of a robust rebound in the previous month’s data, and revisions to previous months were higher, a sort of confirming signal. Furthermore, the separate household survey also shows robust employment gains, hours worked rose marginally and average hourly earnings rose at a rate of 2.6% annualised, equalling the fastest rate since 2009. The US employment data continues to paint a picture of a healthy economy, albeit one that can be characterised as late cycle rather than early cycle.

Chart 1 – US Employment Growth (year on year %). This shows robust growth, albeit late stage

With headline data so strong, what’s not to like? Well, there are the usual quibbles over the number of low paying jobs, and it is interesting to note a faster increase in Government workers in the last three months (who would have thought ahead of an election?), but really the simple question here is one of productivity. With the official data showing very modest economic growth alongside robust employment growth, productivity must be extremely low, perhaps even negative. Either that, or some of the economic data is faulty.

So if we assume that the economic data is correct, then productivity growth in the US should be pretty much at a standstill. Indeed, chart 2 below shows this to be the case. Despite record low interest rates and all the QE, productivity, as measured by the five year rate of change, is basically near zero and at the same low level seen coming out of the 1970s.

Chart 2 – US Productivity

There has been quite a bit of recent debate about low productivity, with Larry Summers putting forward his secular stagnation theme and Robert Norman of Northwestern University publishing a huge amount of work supporting the view that productivity could easily remain very low in the next several decades. There are also those who argue that the current measurements of economic activity do not capture all our output in a digital age. This may have some merit, but our personal view is that the new digital age is giving rise to more leisure time activities than truly productive endeavours, as witnessed recently with the Pokemon Go phenomenon. There isn’t the space for a complete analysis on US productivity today, and we’ll refer back to our note from last October on this subject here.

Moving onto the Bank of England, we have mixed emotions. Brexit undoubtedly presents a shock to the system, and the Bank is making a textbook response by easing policy. Who can blame them for that? We have two areas of concern, however. First, Brexit represents a supply shock, and as Mark Carney admitted, there is little they can do to offset supply shocks. This is a political problem and it’s the politicians who need to act now. Second, with rates so low before the shock, and Mark Carney confirming he is no fan of negative rates, there is very little he can do from here. The Bank is now suffering from past mistakes, as they should have been raising rates two or three years ago which would have left them with more ammunition in the event of a shock to the system.

With the Bank naturally wanting to strike hard and early, they must know that a quarter point rate cut when rates were already so low really won’t have much effect on the real economy, perhaps none at all. So they decided on a total liquidity package of £170 billion, combining purchases of both Government bonds, corporate bonds and liquidity to commercial banks to try and ensure they pass on the rate cut. The problem is that the system is not short of liquidity and so it is hard to see why this should make a big difference to the real economy. The new liquidity system for the banks may be interesting as this could be used in the future to help banks boost profitability but that’s a future potential and not for the here and now.

So we are not really blaming the Bank of England for putting together a stimulus package as they had to be seen to be doing something, we just don’t think it’s going to have a large or durable effect on the real economy. In fact, combined with easy policies in all developed economies, the Bank’s new policies risk pumping up asset prices further with no boost to the real economy. Which brings us back to the debate about bank policies globally.

It has been argued for some time that monetary policies have been successful in inflating asset prices but not helping economic growth. Central banks have resorted to extremely unorthodox policies years after the last crisis and are arguably near the point when they have run out of ammunition and are causing negative effects on the real economy. The Bank of Japan are worried about the effect of negative rates, and we think the ECB in private is as well. There must be concerns within the Fed after last week’s employment report that they are getting behind the curve. Our view continues to be that financial markets are vulnerable if central banks either lose credibility or normalise policies, the bond markets perhaps more than the equity markets.

Central banks are running a fine line between pursuing poor policies that are creating bubbles in asset prices, and maintaining their credibility. How long can this status quo last? We may not have too long to find out. For the Fed, not only is the employment environment pointing to a robust economy and potential for increasing wages, but inflation is set to rise in the next few months because of the low base effect in the second half of last year. How long can the Fed defend no rate rises if these economic signals persist? How low can US bond yields remain if the Fed have to raise rates? How much will the Dollar rise if the Fed raises rates whilst other central banks remain in easing mode?

Having met with a potential investor last week, we were reminded that these macro imbalances have been apparent for some time, and yet they have simply not mattered. Investors have continued to chase yield resulting in higher asset prices despite what we believe to be unsustainable central bank policies and unresolved macro imbalances such as excessive debt accumulation. So, what will be the trigger for the current status quo to be shattered?

In the end, the trigger will be same one as always: Price. So long as prices are benign and volatility is low, investors will be encouraged to keep on taking risk. However, if prices start to fall and volatility begins to rise, then the chances of a new bear market will increase very quickly. Of course, we have had a few false starts in this scenario, when falling prices and rising volatility in August last year and January this year were rescued by waves of central bank support. So, not only do we need to see price signals to trigger a change in market behaviour, but for a really serious bear market, we need to see central banks lose credibility or change policy away from doing whatever it takes regardless of the long term consequences.

So, here are a few price signals we are watching. First, in the bond markets, there may be signs that Japanese bond yields are turning higher. In chart 3 below, we have shown how yields have broken above a key downward sloping trend line and are now trading above the 50 day moving average. With the late September Bank of Japan meeting likely to be key for future policymaking, and possibly indicating that rates will not be cut further into negative territory, a continued rise in yields could be instrumental in forcing bond yields higher everywhere.

Chart 3 – Japanese bond yields may have turned around and be set to move higher from here

In the equity space, it’s difficult to be bearish of US equities with the S&P 500 closing at an all-time high on Friday. We are, however, intrigued by the continued lack of performance in Europe. Chart 4 below shows that the Eurostoxx 600 index remains below chart resistance and its own declining 200 day moving average. We are willing to hold a bearish position so long as the 350 chart resistance area remains intact.

Chart 4 – The Eurostoxx 600 Index remains below chart and moving average resistance

The US Dollar remains in a large consolidation pattern as measured by the DXY Index as seen in chart 5 below. This consolidation looks like a continuation pattern, and if current conditions as described above persist, then the Dollar may well be set to benefit and perhaps break out above the top of the range around 100 or 4% above current levels. In any event, so long as the bottom of the range around 93 holds (3% below current level), then we will continue to think bullishly of the Dollar in the big picture.

Chart 5 – The Dollar continues in a high level consolidation that should eventually be broken on the topside

We have noted many times in the past that a strong Dollar presents risks to both the real economy and also asset prices, and so this particular chart bears very close watching indeed.

So, to try and wrap this week up. The status quo of rising asset prices, low volatility and dovish central banks continues. However, we feel that the status quo is actually quite fragile, but we need to see price signals or triggers before we can say that the status quo is actually changing. We are watching bond markets and the Dollar closely for signals that things are about to change, and remain modestly bearish of equities via a short position in European markets. If bond prices fall and the Dollar rises in the weeks ahead, then perhaps August will be anything but a quiet month, but if the status quo maintains, then we can all head off to the beach and ignore all electronic gadgets.
Stewart Richardson
Chief Investment Officer