Schroders Live: Central banks’ options, and Q2’s biggest risks

Gareth Isaac

Gareth Isaac

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Keith Wade

Keith Wade

Chief Economist & Strategist

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Cranny began by referring to this week’s warning from the International Monetary Fund (IMF) that the global economy risked stagnating as a result of its prolonged period of slow growth. Wade, however, played down the significance of the IMF report.

“The new IMF forecast is capturing a lot of the worries we had at the beginning of Q1,” Wade said. “In some ways the IMF is a lagging indicator and is looking in the rear view mirror. Those worries we had at the start of the year are starting to fade as we’ve had a bit more stability in China, the US and rest of the world.”

Are central banks out of ammo?

Following the introduction of negative interest rate policy by a number of the world’s central bankers, Cranny asked if this trend will continue and whether it means central banks have run out of monetary policy ammunition.

“Central banks are in a very difficult position,” Wade said. “They have to behave as if they have more tools in their toolkit. But privately, and if you read between the lines, they are saying that they’re very near the end. There’s very little more they can do in terms of delivering stimulus.”

He also pointed out that negative interest rates actually have lots of adverse effects, particularly on the banking system and its profitability, and so could actually be counter-productive. The next focus needs to be fiscal, rather than monetary, Wade thinks.

“What I see is central banks reaching out to governments asking for fiscal stimulus,” Wade said.

Isaac concurred, saying that there’s no real alternative.

“In the UK, the Chancellor George Osborne is tightening fiscal policy, which is counter-intuitive. And we saw the same during the eurozone crisis,” Isaac said.

“Normally when you go into a recession or a poor period of economic growth, you have the twin effects of one hand cutting interest rates and on the other, governments increasing spending and cutting taxes. That’s not what happened this time and why we had this long, drawn-out, subpar recovery.”

What’s left to stimulate the global economy?

Isaac said he can’t see that central banks can do anything further to stimulate the economy – aside from extreme measures like so-called “helicopter money” (effectively printing money to hand out to citizens) or monetising debt (whereby a government directly issues new debt to the central bank, thus increasing the monetary base).

Whether the necessary fiscal stimulus comes to fruition is doubtful, however. “The best we can hope for in Europe is that they relax the constraints a little, allow the so-called “automatic stabilisers” to work (e.g. benefit spend to rise and corporate and personal tax revenues to fall), and that we don’t see the same kind of austerity we’ve seen in past,” Wade said.

Should we be optimistic on emerging markets?

Emerging market currencies surged in the first quarter, which Isaac put down to a “virtuous circle” of rising commodities, a weakening dollar and China improvement. Within emerging markets, Wade sees reasons for optimism.

“There are signs on the ground that export orders and manufacturing activity are beginning to improve in parts of emerging markets,” he said.

“These are helped very much by the stability and rally in commodity prices, but also by a turn in the global inventory cycle. We’ve seen manufacturing and trade very subdued as companies have tried to work off this excess inventory. It looks like this is now beginning to happen; this will help emerging markets as we go forward.”

He thinks that a more stable environment for emerging markets could make the Fed more likely to raise rates again as the global market volatility caused by such a move is likely to be reduced.

Where next for the Fed?

Wade thinks the Fed needs to hike again soon.

“It’s clear interest rates overall are very, very low; -1% in real terms, for an economy that has unemployment at pretty close to equilibrium, is really unusual. The Fed will have to move rates up gradually, but they are also mindful in an election year that there is a limited window, so they really need to go in the next few months.”

Who will benefit from oil price gains?

Oil’s recovery this year has been one of the biggest drivers of the market rally. So, Cranny asked our pundits: if oil prices continue to rise, who will be biggest winners and losers geographically?

“The winners will be the exact reverse of the last couple of years,” Isaac said. “One of the worst affected will be Europe, as it doesn’t produce a great deal of oil but consumes a lot.”

Wade agreed that in some ways a higher oil price will be negative for Europe, but in another way it will be welcome.

“Lower oil prices have been one of the things driving the European recovery,” Wade said. “Consumer spending in Germany, for example, is really strong and it has been a boon for the Germany economy. Rising oil prices will unwind some of that. But (ECB President) Mario Draghi also looks at its impact on headline inflation1 , so in one way it will be welcomed because headline inflation will go up and Europe will move away from deflation. “

Are investors overestimating China’s impact on the global economy?

China remains an important focus for investors globally, although Isaac thinks people now overestimate its impact on the rest of the world as its dynamics have changed.

“The market is obsessed with Chinese headline growth levels. Ten, or even five, years ago they were important for the rest of the world purely because they had a lot of infrastructure spending, used a lot of commodities and drove global growth,” Isaac said.

“But the balance of growth in China is moving from the industrial to service sector, which has a far lower effect on the rest of the global economy. 5% today is not the same as 5% five years ago. Now it comes from companies like Alibaba with goods produced in China, from a website in China and with its profits in China. It has far less impact on the rest of the world.”

What are the biggest risks facing investors in Q2?

Cranny concluded the discussion by asking Isaac and Wade for their two biggest risks for the quarter ahead.
The first is the upcoming referendum on the UK’s membership of the EU.

“We think the near term impact on GDP growth could be quite severe in the event of a Brexit – about 0.9% lower in the following year,” Wade said. “This is because you would have a hit on investment growth and consumption, so you would see a bit of a pause in the UK economy. The real focus will be the pound and whether it could fall further. We think it could fall further, and this would eventually help the economy, but in the near term would affect inflation.”

The second main risk for the quarter, according to Wade, concerns currencies.

“Currency markets are the other area we are keeping a close eye on. They are more stable but we’ve seen a big move in the yen. The Bank of Japan doesn’t want that and it might act, which could result in the currency wars kicking off again.”

1. Headline inflation is a measure of the total inflation within an economy, including commodities such as food and energy prices.