Central banks count the cost of slowing growth

Graham Smith

Graham Smith - Market Commentator

Interest rates remain high on the global agenda, not yet completely drowned out by trade talks between the US and China, or even Brexit. It’s right they should too, because interest rates have fundamental effects on the relative attractions of equities, bonds and cash, and so the prospects for our investments and pensions.

The outlook for US interest rates remains especially important. The US was a major engine of world growth last year, while growth trends in Europe, Japan and emerging markets struggled to maintain traction. If US rates are raised too far or too soon, global growth will be at risk.

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That’s why markets pounced on a statement made by the US Federal Reserve Bank Chair Jay Powell at an economic meeting in Atlanta last month. In a tone distinct from that of many previous statements, Powell indicated the Fed is attentive to financial markets and is in no rush to lift US interest rates further ¹.

Interest rates in Europe and Japan are still at rock bottom, even after many years of economic growth, chiefly because inflation has remained low. This poses a problem come the next economic downturn, because there’s no room left to cut rates in order to prolong growth.

The US has not fallen into the same trap. Growth there has been considerably stronger of late than in most other places, providing the headroom necessary for interest rate rises. Since November 2015, rates have been increased nine times and by 2.0%, despite inflation staying grounded². That leaves a bit of room at least for rate cuts should the US economy begin to run out of steam.

All the signs are the Bank of England is envious of this position but has been unable to engineer it. It made a start in 2017 by lifting rates by 0.25% and following this with a similar rise in August last year. Since then, the emphasis has been on reasons not to raise rates, such as Brexit risks and weak overseas growth³.

The chance to build in some more wriggle room has probably now gone. The Bank’s fears culminated this week in a statement from Governor Mark Carney to the effect that Britain leaving the EU without a deal or transition arrangements in place would be an economic shock⁴.

Then, of course, there’s China, whose economic slowdown is causing another headache for central bankers. Earlier this month, the governor of the central bank of nearby Australia warned domestic and international risks made lower rates more likely⁵. India went further, cutting rates this month⁶.

Ten years on from the start of the global financial crisis, and after nine years of a growing world economy, it may seem odd that the world’s central banks remain so cautious. Even the US, currently with a booming domestic economy, is constantly snagged with the idea that further rises in rates will vaporise growth.  

A major reason for the current predicament faced by central bankers is that the world economic recovery we have seen since 2009 hasn’t followed a traditional path. Accepted economic theory would suggest that, by now, low interest rates and rapid employment gains ought to have driven up inflation to much higher levels than we see today.

One theory rests on the idea that the psychological impacts of the global financial crisis ran so deep that people and companies have changed their behaviours, driving employees to accept lower wage settlements. Other ideas include new technologies bringing down the prices paid by consumers and even the advent of “the sharing economy” typified by Airbnb and Uber, which leads to the greater utilisation of existing goods. 

So it is against this background that several central banks have nudged down interest rate expectations this month. With Italy entering a recession last quarter and growth in the eurozone also at a low ebb, expectations will be growing the European Central Bank will follow suit⁷.

Clearly, reduced chances of higher interest rates are a positive for equities, which have risen since the start to the year, even under the clouds of Brexit, economic and political risks in Italy and an uncertain outcome to US-China trade talks.

One risk now might be that we see a change in emphasis at the Fed – now that markets have rallied and as what spare capacity is left in the US labour market continues to get used up. That could put a slightly different complexion on matters for other central banks too.

For now though, the downward pressures on interest rates and cash returns remain considerable. For the latter, whatever light may have been glowing at the end of the tunnel looks like it may have dimmed again.

Changing expectations about interest rates and the different ways the various types of assets are affected highlight one of the main reasons for adopting a balanced approach to investing. Maintaining at least some exposure to each of the main asset classes provides investors with the best chance to ride out short term swings in market sentiment.  

This approach has been made easier recently by the emergence of the Fidelity Select 50 Balanced Fund. Launched just over a year ago, this fund has already proven its worth in the volatile market conditions we saw in 2018.

This fund offers two levels of added value: first, it invests mostly in funds that have made it onto Fidelity’s Select 50 list. Second, the Fund’s overall exposures to equities, bonds and cash are constantly monitored and adjusted by an experienced manager, based on detailed assessments of the world economy.   

 

Source:

¹ Bloomberg,05.01.19
² Federal Reserve System, 19.12.18
³ Bank of England, 30.01.19
⁴ Reuters, 12.02.19
⁵ Reserve Bank of Australia, 06.02.19
⁶ Reserve Bank of India, 07.02.19
⁷ Istat, 31.01.19, and eurostat, 10.01.19

Important information

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