The markets’ pole star is fading

Since 2009, major central banks such as the US Federal Reserve, the European Central Bank (ECB), the Bank of Japan (BoJ) and others have largely determined the trends in the major asset classes of both emerging and developed countries: equities, sovereign and corporate bonds, and currencies. Investors found their guiding light in the central banks. Markets are once again likely to find themselves under their influence in 2016, but without as much clarity or reliability as before.

For some time, we have employed a dual analytical framework for interpreting the actions of central banks. The first aspect concerns the nature of the monetary regime within which markets evolve. In other words, the decisions and communication of central banks together determine the trends in conventional variables such as economic growth, inflation, earnings growth, etc. The second aspect concerns the way in which the monetary regime created by central banks responds to three factors: desynchronisation, heterogeneity and non-cooperation. Desynchronisation because the Fed is gradually withdrawing from its programme of quantitative easing, while the ECB is beginning and the BoJ accentuating it. Heterogeneity because neither the ECB nor the BoJ share the style of monetary policy adopted by the Fed to guide market expectations (‘forward guidance’). Non-cooperation because central banks are making decisions without consulting each other, nor coordinating their efforts in the interests of the global economy.

Since 2009, these two aspects have been very positive for investors. Central bank action has been so powerful that equity markets soared – US stocks by over 200% as measured by the S&P 500 and European stocks by nearly 140% according to the Stoxx 600. Investors in sovereign bonds, meanwhile, owe a large measure of their performance to the fall in 10-year yields to well below their equilibrium level. The equilibrium is normally considered to equate to nominal GDP growth, suggesting that long-term US interest rates should be above 3.5%, compared with their 2%- 2.5% range since the beginning of the year.

In 2016, financial markets will scrutinise the words and actions of central banks with a similar obsession. Nevertheless, the behaviour of central banks may change and their role as a guiding star fade. Why? First, the timing of the initial monetary tightening by the Fed, probably of 25 basis points, is unclear. After some months of postponement, the date is highly speculative, creating a climate of pervasive uncertainty. This puts any upward trend in stock markets into question. The S&P 500 has risen a mere 2.7% in 2015, against an average of more than 18% annually between 2009 and 2014.

Moreover, the three factors of desynchronisation, heterogeneity and non-cooperation will continue to boost market volatility. While by early November the Stoxx 600 had risen by almost 13% in 2015, its year-to-date performances by April, August and September were 17%, 8% and 4%, respectively. Desynchronisation and non-cooperation in monetary policies together generate destabilising shocks to asset classes. Thus, the dollar appreciated by nearly 25% against the euro between the end of 2014 and the first quarter of 2015, while the currencies and bonds of emerging countries violently uncoupled during the summer.

Certainly, central banks will continue to give reassurance to financial markets. Certainly, despite desynchronisation, the massive liquidity injection will continue: we expect more than $1,400 billion in 2016. Certainly, none of the central banks wish to undermine the mechanisms which are reflating asset prices, and which have been an implicit objective of monetary policies since 2009. Nevertheless, they are likely to find it more difficult to guide markets with the same efficiency. Investors should therefore expect trends in asset classes to be significantly weaker and more volatile. In such an environment, we would emphasise once again that portfolio diversification is the most important yardstick of good investment. For the bolder investor, the ups and downs of the market should provide opportunities for tactical moves, and firms exhibiting strongest growth should offer the highest potential return.

Christophe Donay
Head of Asset Allocation & Macro Research
Chief Strategist