Global liquidity to tighten further
In today’s inter-connected, globalised economy, dollar liquidity is key. Its importance as the grease in the wheels of the global financial system can be easily under-estimated. In simplistic terms, when dollar liquidity is abundant, global trade tends to be strong, the dollar is typically weak, commodity prices rise and equity markets do well. In the post-financial-crisis world, these relationships seem to have become more pronounced.
But when dollar liquidity tightens, all of these things go into reverse. We believe that liquidity conditions in the global financial system have already started to contract and that this is likely to gather pace in the second half of the year. The primary reason for this is that central banks, led by the Fed, are now tightening policy.
If the Fed’s dot plots are to be believed, we should expect two more 0.25% interest rate increases in 2018, alongside quantitative tightening (QT) at an accelerating rate, as the world’s biggest central bank progressively unwinds the biggest monetary policy experiment the world has ever seen. Indeed, the Fed, buoyed by the apparent strength of the US economy, has already increased interest rates by a quarter of a percent in March, maintaining its hawkish outlook for monetary policy going forward.
Meanwhile, the Fed’s quantitative tightening programme will likely cause global liquidity conditions to contract further. If maintained on course, its QT will run at c.$600bn annualised in the fourth quarter of 2018. This is a huge amount of money that is being drained from the financial system. We believe this is likely to cause the dollar to strengthen, which given the causality outlined earlier in the article, will lead to commodity price weakness, equity market momentum weakening and, contrary to popular wisdom, sovereign bond yields falling not rising. Every single period of QE in the US caused Treasury yields to rise, even though the stated aim of the policy was to push interest rates down. This is because by its very nature QE is inflationary. By extension, QT will be deflationary for the US economy with potential implications for global financial markets and even the world economy as well.
Indeed, we are already seeing the consequences of the Fed’s tighter monetary policy most aggressively in emerging markets thus far, with steep declines in many South American and Asian stock markets and increasing signs of tension in foreign exchange markets.
The Fed is not however the only large central bank that is tightening monetary policy. Across the Atlantic, the European Central Bank (EBC) has been reducing its asset purchase programme (similar to quantitative easing in its aims) from €60bn to €30bn per month, and plans to completely end it by September 2018. Recent political events in Italy, coupled with weaker macroeconomic data from across the eurozone, could lead the ECB to change its plan but, as things stand, this represents an additional prospective liquidity headwind for financial markets to grapple with.
More positively, there is one developed economy whose money supply growth outlook is not facing the impact of the withdrawal of extraordinary monetary policy. The UK economy has sustained nominal broad money supply growth of around 5% per annum recently – this, coupled with all the other positive trends in the UK economy that we are seeing (a strong labour market, a healthy banking system and rising real wages, for example), is enough to suggest that domestic growth can accelerate in the months ahead, leaving consensus expectations looking far too low.
Consequently, from our perspective there are valid reasons to expect tighter global liquidity conditions to act as a brake on economic growth and on financial asset prices. Our contrarian strategy however has actively avoided areas of the market that look most vulnerable to this withdrawal of liquidity. Importantly, there still exist pockets of opportunities, especially among the domestically-focused UK stocks, which trade on valuations that, in our view, do not reflect their long-term potential to deliver attractive returns.
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