Shifting Sands

Investor enthusiasm is an enduring hallmark of the last several years amid low volatility and high investor confidence. Despite a cascade of unsettling geopolitical developments, investors and the markets in which they operate have dutifully soldiered on. Whether it’s the S&P 500 Index achieving a new high when it broke through 2000, or the remarkable performance of developed market sovereign debt, the pacific attitude of investors that “things will work out fine” appears to be an increasingly catholic psychological trait. A common feature among investors that perpetuates this state is a belief that the current interest rate regime will continue. Cheap and easy money is a powerful elixir.

In every era, however, there is an inflection point; a moment in which the course of events moves slightly and the sands beneath begin to shift. There was such a moment last Friday when the world’s central bankers gathered for their annual confab in Jackson Hole, Wyoming. Since 1978, the Federal Reserve Bank of Kansas City has hosted it annual Economic Policy Symposium wherein “… central bankers, policymakers, academics, and economists from around the world” discuss the big issues of the day. This year the focus was on labour markets. In remarks to the conferees, Drs. Yellen and Draghi communicated what appeared to be nuanced, but important, changes in their policy posture that could have meaningful consequences for their respective economies.

Dr. Draghi’s evolution

The European Central Bank (ECB) president, perhaps finally recognising the limitations of monetary policy, endorsed an easing of the eurozone’s restrictive fiscal policies to help generate demand (Translated: were governments to spend more and cut taxes, economic activity would likely rise.) More importantly, he suggested the need for price stability, ie., inflation, to be in a subsidiary position to that of reducing unemployment. Also reading between the lines, it seems that the ECB president is acknowledging that a cheaper currency is required to provide relief from the deflationary pull that internal devaluations create in an economy.

This is hardly revolutionary stuff. When businesses and governments practise austerity by cutting wages, reducing the numbers of employees, and slashing benefits, all in the service of becoming more competitive, prices tend to fall. It is a policy of subtraction.

External devaluation through currency depreciation always has been the path of salvation for those countries struggling with high debt burdens and sclerotic economies. The bank’s consideration of outright purchases of asset-backed securities represents the first step in a more brawny approach to monetary policy. The threat of additional forms of quantitative easing (QE) will help to put downward pressure on the euro, and continue the trend that began in May. Properly exploited, a declining euro and falling interest rates can be the tonic policymakers and investors have been seeking. A cheaper currency will help make the bloc’s economies more competitive as the cost of its goods and services falls relative to its trading partners.

More importantly, if the central bank affects a weaker euro, it provides cover for policymakers to reform fiscal policy, labour laws, business regulation etc, all in an effort to generate a healthy and competitive economy. Of course, this assumes that the leadership of each of the bloc’s countries finds common ground and builds the coalitions necessary to do this. Judging from recent history, the formation of such a “Policy Xanadu” is unlikely.

In an ironic turn of events, President Francois Hollande dismissed a group of “rebel cabinet” members for essentially espousing Dr. Draghi’s thinking on fiscal policy. Although the language they used to make the point had an incendiary flare, the gist of their argument had merit, as the French economy ground to a halt in the second quarter, mirroring the broader Eurozone.

Fiscal considerations aside, the potential change towards a more accommodative monetary policy has significant ramifications for investors. Consider the American and Japanese equity experience on the heels of their falling currencies. The case for Eurozone equities (given their recent weak performance and valuations against this evolving policy backdrop) is considerable. It certainly represents the coming to fruition of the case we made for overweighting portfolios to this market.

Additionally, the pressure on euro government yields is likely to continue as the spectre of additional QE hangs over these markets, and the threat of deflation persists.

Dr. Yellen’s reality

Dr. Yelln’s speech made clear to anyone who read its six pages that the Federal Reserve (Fed)’s position is evolving. I have long argued that the cult of the central banker is wrongheaded. They have been portrayed as great economic seers. In fact, some were even referred and deferred to as oracles. If the perception of these “Lords of Finance” is kind, the reality is less so. Central bankers have no greater insight or forecasting ability than those over whom they hold sway. In the case of the Fed, Dr. Yellen’s comments revealed its struggle to gain insight into the direction and velocity of economic activity of the world’s largest and most vibrant economy is no different (despite the legions of Ph.D.s at their disposal) from that of private market players. It’s clear from her speech that the Fed has underestimated the vitality of the economy, and seems to be struggling to create a framework of analysis to judge the right policy response. In a moment of clarity and simplicity uncharacteristic of those in the economics profession, she averred: “There is no simple recipe for appropriate policy…”. Really.

The bottom line is straightforward: as the Fed grapples with how to judge the health of the economy, the likelihood rises of “falling behind the curve” in setting the appropriate interest rate. This likely will force the Fed to respond by altering interest rates sooner than those who blithely commit capital to 10-year Treasuries at yields below 2.4% might wish. To be sure, the emergence of an interest rate that does not need a microscope to be observed will be disruptive (and even destructive to those who are long leverage and duration). However, if the cause of a changing interest rate regime is faster and more durable growth, any setbacks are likely to be temporary.

These may be the quiet, concluding days of summer, but they are not without event.