After a number of central bank meetings and speeches, we thought we would take a quick look at what happened. We are on the road this weekend, and so this week’s commentary is both shorter than usual, and there are no charts. We will no doubt have plenty of time in the months ahead to look at central bank policies in more detail. For now, with markets still relatively benign, volatility in near freefall, and the beach beginning to beckon, longer term concerns may be a bit premature. For our part, we continue to see signs that a multi month topping process is close to starting. Let’s crack on with a quick review of recent central bank activity.

First up, the Bank of England voted to keep policy unchanged last week, but in a surprise move, the vote was much closer than the markets thought. Previously, the vote was 7-1 for no change in policy whereas this time round it was 5-3, ie 2 voters on the committee thought it was the right time to be raising rates now. With inflation coming in at a four year high (2.9% on the headline rate and 2.6% on the core rate), which is some way above the Bank’s mandated target, some would say that it is right to be looking to raise rates, especially as they are still at the zero boundary.

We would point out that from July, the year on year base effect from the exchange rate should begin to help inflation stabilise and then maybe subside a bit. Furthermore, with political uncertainty likely to remain for some time, and consumers facing the headwind from negative wage growth, we are not sure that the committee will be actively increasing rates in the second half of the year.

So yes, the voting pattern has to be seen as a modest shift to a hawkish bias, and is probably warranted when considering the broad state of the economy and interest rates at close to zero. But the timing looks a bit odd, and any tightening cycle is likely to proceed at a snail’s pace if at all. As such, we expect very little in the way of market impact other than what has happened already.

Of much greater interest was the rate rise delivered by the Fed and the hawkish tone struck by Janet Yellen in her press conference – hawkish for her anyway. It would seem that the Fed is committed to raising rate so long as nothing deteriorates. Officially, they describe this as being data dependent but, like many, we suspect that it really means stock market dependent, i.e. they will keep tightening policy so long as the equity market is behaving itself.

We have been in the camp that says the Fed will keep going until something breaks, either in the US or elsewhere. What really got our attention was Yellen’s comments surrounding balance sheet reduction. It sounds very much like they want to start this process before the end of the year, and she expects this process “to run in the background; a bit like watching paint dry”.

It is notable that it is likely that Janet Yellen will be replaced at the end of January 2018, and so she won’t be at the Fed to watch the paint dry. Frankly, we think she may be a bit delusional on this point. We think that the balance sheet reduction could eventually create fireworks in markets, and that her expectations are only intended to try to influence markets; a form of forward guidance if you will

Next up, two senior policymakers at the Bank of Canada spoke last week, and seem to have officially started the process towards tightening policy, as their speeches came across as quite hawkish. This was unexpected as many are still looking at the weak performance of energy prices and signs of weakness in their housing market (Toronto specifically) as reasons for concern over the economy. But again, with the economy performing okay at the moment, perhaps these guys are struggling to justify rates at the zero boundary.

And finally, the Bank of Japan held policy unchanged; i.e. doing as much as it possibly can via QE, negative rates and yield curve control. And frankly, there is little sign that Kuroda San wants to make any changes, although as noted previously, QE is likely to undershoot their Yen80 trillion target as they implement their yield curve control policy, and as such, there is a form of tapering occurring.

We also have to remember that the ECB are likely to be reducing asset purchases going into next year, and the Peoples Bank of China are reining in liquidity injections, money supply growth there is tailing off and market interest rates have been allowed to rise.

So, when we step back, we see all the major central banks either actively tightening policy, setting the groundwork for tightening policy, or reducing stimulus. This is very different from a year ago when all measures were being employed to stave off problems emanating from a weak global economy and a wobbly Chinese situation. =

The question is can this global move towards less accommodation with the US Fed tightening be achieved with no mishap in either financial markets and/or the global economy? History says no, and that a global soft landing and calm financial conditions are not to be expected. Furthermore, there is very little margin of safety in financial markets, and the downside in the event of a policy error and recession is very large indeed.

We have been at pains in the last month or two to set the scene that our greatest fears lay later in the year, but that we expect a multi-month topping process to begin imminently. Absolutely nothing we see in terms of central bank policies nor financial market performance has changed our mind. This topping process may not change things immediately in terms of broad index levels, but we view that rapid rotation between growth and value in the last week or so as yet another sign of the increasing volatility that should be expected in the months ahead.

We have also been at pains to suggest that those considering making changes to their portfolios should do so whilst there is a general sense of calm in markets, and the exit is not too crowded. This may sound like a broken record touting the style of management we practice here at RMG. However, we truly believe that if we are correct about prospects for financial markets later this year, then the vast majority of investors will be horrified by the lack of liquidity available in a bear market, and just how narrow the exit will be.

Stewart Richardson
RMG Wealth Management