The cautious optimism thesis to which we have subscribed since the latter part of last year continues to play out, but has been repeatedly challenged in many ways. As soon as one headwind appears to abate – e.g., fiscal retrenchment in the United States – another emerges, e.g., slowdown in emerging markets. But the fact remains that the global economy is digging itself out of the hole [1] created by the great financial crisis and the subsequent Eurozone crisis, albeit at a slow and uneven pace.

The recovery is also uneven geographically. In the United States, the healing of the labour and housing markets have enabled consumption to move forward while the industrial rebound has begun to take hold. To be sure, GDP growth has been far from impressive but is set to improve as the fiscal drag recedes. Some other developed markets – notably Japan and the United Kingdom – are also experiencing cyclical upswings while Europe is emerging from its recession. In contrast, emerging Asia and Australia have slowed down largely due to the rebalancing in China. Other large emerging markets have also decelerated thanks to combinations of deteriorating terms of trade, weaker exports and higher inflation. In short, the economic cycle is improving among large developed markets while it is deteriorating in most emerging markets.

We have previously argued that there are four reasons to be cautiously optimistic on the global recovery: more resilient growth, the passage of time, ongoing monetary policy accommodation and reduced tail risks. While the first three remain valid, the last reason is again a concern.

Despite weakness in emerging economies, global growth remains, in aggregate, relatively resilient. While growth is slow it is steady and leading indicators suggest that the expansion will continue at a moderate pace.

Meanwhile, the passage of time continues to work its wonders. It is now almost five years since the nadir of the Great Financial Crisis. In the United States, households, which remain important drivers for global growth, have delevered ever since with the debt to income ratio falling from 128% to 104%. The current ratio has now converged with the long-term trend, suggesting that the process may be at its last leg. Even assuming a much more aggressive end point, say returning to where it was before financial deregulation accelerated in the 1990s, suggests that the adjustment is considerably closer to the end than the beginning, with the most painful phase in the past. The United Kingdom has seen a similar development with the ratio of household debt to disposable income falling 23%. However, at 140% it still remains considerably higher compared to the United States. Deleveraging in the Eurozone is of a different character with greater focus on banks and sovereigns. The overall process is less advanced and at a more painful stage.

The outlook for monetary policy has become more uncertain due to changes in strategy among all major central banks. This is ironic as at least three of them – the Bank of England, the European Central Bank and the Bank of Japan – have recently implemented policies to reduce uncertainty. These shifts are nevertheless complicated, not least from a communication perspective, and often have unintended consequences. That most central banks have or are in the process of changing their leadership further complicates the situation. At the end of the day, we believe that monetary policy will continue to be accommodative, but perceived transitions to new reaction functions under fresh leaderships add a layer of (temporary) unease to global financial markets.

The area which has not evolved in a positive direction is the quantum and severity of tail risks. While some risks have certainly been notably reduced, others have emerged. For example, there is an increased probability of a hard landing in China and other emerging markets. Due to its low growth rate, the world economy remains more vulnerable than usual to shocks which make it important to identify and monitor these potential sources of risks. This creates two main problems: first, and most obvious, is a significant cost associated with any tail risk materialising. Secondly, the existence of these risks reduces confidence in the outlook, which in turn results in more defensive decisions which have sub-optimal growth implications. The latter is evident in the large amount of cash corporates are currently holding on their balance sheet; in the United States corporates hold close to a record $2.5 trillion in cash or cash equivalents, according to the latest flow of funds report.

Notwithstanding these concerns, we stick to our cautiously optimistic baseline scenario. A key conclusion is that the combination of the further economic recovery, significant cash hoards and accommodative monetary policies should support risk assets while fixed income curves should generally steepen as ongoing policy accommodation lends support to front ends while securities further out adjust to the improved growth outlook, the trough in inflation rates and the Federal Reserve’s potential withdrawal from quantitative easing. This theme is evident in the flow data which shows that investors’ preference for equities supersedes fixed income securities.

Mixing it up, Fed style
“Our target is not 7, it’s not 6½, our target is maximum employment, which, according to our projections, most people on the Committee think is somewhere between 5 and 6% unemployment, and that’s where we’re trying to get to. The 7, the 6½ — these are guide posts that tell you how we’re going to be shifting the mix of our tools as we try to land this ship on a, you know, on a — in a smooth way onto the aircraft carrier.”
– Federal Reserve Chairman Ben Bernanke, 19 June 2013

For all the talk about the economic recovery in the United States (including from ourselves), the official growth numbers have been tepid, even after the keenly awaited GDP revisions last month. Gross domestic product has grown at an average of 1.4% over the past four quarters, down from 2.8% in the preceding four quarters. However, momentum turned positive in the second quarter despite fiscal headwinds. Leading indicators for the third quarter are mixed but generally suggest that growth will improve. As the fiscal drag recedes, growth should accelerate further in the fourth quarter and, as long as the economy is not hit with a substantial shock to growth, it is likely to be above potential for a protracted period.

This cyclical lift is likely to be followed by a turn in core inflation rates. Save for a few months last year, core inflation [2] has decelerated for the last 15 months, falling from just over 2% to 1.2%. Courtesy of base effects and the stronger economy, the year-on-year measure should gradually move higher from here, ending this year around 1.4% and next year around 1.6%. The risk is tilted to the upside.

Our growth and inflation views, although fairly optimistic, are below the central tendency forecast of the Federal Open Market Committee (FOMC). That said, we don’t think the FOMC will be sufficiently disappointed by the data to materially delay its tapering plans, but the softness of the upswing in growth and inflation, both absolutely and relative to the Fed’s central scenario, should ensure that when the Fed changes its mix of tools it will be done in a manner that continues to provide significant accommodation. The most plausible scenario is that the beginning of the tapering process is accompanied by alterations to the existing thresholds. The simplest way to do this is to lower the unemployment threshold, something Bernanke alluded to earlier this summer.[3] Another possibility is to make the unemployment rate threshold conditional on a lower band for inflation or labour force participation. The former would satisfy those FOMC members which have disinflationary concerns while the latter would safeguard against the ‘wrong’ type of unemployment rate decline.

The overriding point here is that although the Federal Reserve is set to begin to wind down its asset purchases, it will remain very accommodative even as the economic recovery gains momentum. At least that is the intention of the current leadership. Given what we know about the front-runners to replace Bernanke next year (Summers, Yellen and Kohn) we don’t think the new Fed Chairman will alter the strategy in a significant fashion.

Draghi’s not so magic touch
“Let me also say that current expectations of rate hikes in money markets are, according to our assessment, unwarranted. As I have said, current data confirm our baseline scenario, and risks are on the downside. So, developments have to be significantly better than our current baseline scenario for an outlook for price stability in order for us to change our guidance.”
– ECB President Mario Draghi, 1 August 2013

First the good news: the cyclical news have improved noticeably over the summer. During the second quarter the Eurozone economy grew by a respectable 0.3%, its first expansion since the third quarter of 2011. Purchasing manager indices have moved up for four months in a row and in July the composite index broke the important 50 level for the first time in two years. The improvement has been geographically broad-based. Consumer spending has also stabilised, supported by better income and confidence. In short, the Eurozone is emerging from the recession. Meanwhile, on the fiscal side there has been ongoing progress in most countries.

Against this are the ongoing deleveraging process and its associated credit crunch which all but ensures that the recovery will be modest and suffer from downside risks. Consequently, Europe is unlikely to experience the kind of upswing which unleashes bullish animal spirits. Instead, the most plausible outlook is a long-term “muddle through” scenario, i.e., years of sub-par growth. The problem with years of sub-par growth is that it is not politically feasible.

Europe is experiencing a job crisis of epic proportions. In the aftermath of the Great Financial Crisis, Europe’s unemployment rate increased very rapidly during 2008 and 2009.[4] Other developed markets experienced similar, or even larger, unemployment rate explosions. But the real menace is what happened later. While unemployment rates in the United States stabilised and later fell (slowly) as the crisis abated, Europe’s unemployment rate soon soared again. Over the past two years it has increased by another 2%. It now stands at 12.1% compared to 9.9% when the euro was introduced in January 1999. This matters because mass unemployment is politically untenable over time and creates uncertainty. Over the past year this has been largely ignored as politicians and financial market participants have basked in the afterglow of Draghi’s infamous ‘whatever it takes’ speech.

However, there are a number of issues that are converging this autumn which threaten to intensify the crisis at a time when governments enjoy limited political capital.

First, the political situation in Italy has the potential to deteriorate on a number of fronts. Berlusconi’s conviction is the most immediate threat to the government. For now it appears that Berlusconi’s party, the PDL, will continue to support the coalition but demands for a presidential pardon and threats of mass resignations suggest that the support may be fleeting. Another issue is the potential congress for Prime Minister Letta’s Democratic Party which would create uncertainties about the prime minister’s future. Finally, this fall the government has a challenging legislative agenda in order to meet its fiscal targets.

Second, in Spain the corruption accusations against Prime Minister Rajoy refuse to go away. Allegations of skullduggery have dominated Spanish press throughout the summer following the arrest of Luis Barcenas, the former treasurer of Rajoy’s Popular Party. The Popular Party’s support in the polls has unsurprisingly fallen rapidly as a result. The saving grace for Rajoy is that the opposition socialist party is also tainted by similar claims. Although this may save Rajoy’s government in the short run, there is a risk of a political vacuum which will make it difficult for financial market participants to assess the situation with any confidence.

Third, Portugal will need a new programme over the next few months. Given the country’s fiscal situation and depressed growth rates, this may involve a restructuring.

Fourth, there are still questions about the debt sustainability in Greece and Cyprus. Any restructuring there would have to involve the official sector which would be politically challenging in Northern Europe.

Associated with these issues is the German election in September. Theories abound that Berlin’s attitude to the European crisis will evolve meaningfully once the election is out of the way. We disagree. Reading and studying the main contenders in that election, it seems to us that there are more similarities than differences on Europe, suggesting that current attitudes will remain largely intact.

The mere existence of the ECB’s Outright Monetary Transactions (OMT) programme may not be able to contain markets if political uncertainty and tension increase once more. As the market reaction to the last two ECB press conferences attests, verbal intervention alone is not effective if it is not deemed credible. If doubts start to grow about the unity of purpose among Europe’s leaders, markets are likely to demand action which, at least initially, could put peripheral bond markets under pressure.

The ECB appears to finally understand the risk of a prolonged slump in Europe. For example, ECB executive board member Benoit Coeure eloquently described the risk of a Japanisation of Europe in a speech earlier this summer.[5] Encouragingly, the ECB also understands it has an important role to play in avoiding such an outcome. As a result it introduced its forward guidance in July which was re-affirmed in August. Market participants remain sceptical, however, and doubt the ECB’s ability to deliver. This lack of credibility was apparent when the European front end sold off following Draghi’s observation in August that the current pricing in money markets is ‘unwarranted’. This is clearly a problem for European policymakers and illustrates that verbal interventions are only effective when they can credibly be backed up by actions.

For the ECB it is not enough to stabilise the markets at current levels. Draghi’s comment about market pricing being unwarranted signals that the ECB wants more accommodation, i.e., for rates to go lower than the currently are. But to get them there, mere talk is no longer enough. The tepidness of the recovery, likely decline in inflation rates and declining excess liquidity all suggest that the ECB leadership is correct in wanting rates lower. But to get them they will likely have to engage in some ‘real’ action that goes beyond indications of what they might do in the future. Of course, monetary policy alone cannot resolve the European crisis. A credible European framework, including sustainable fiscal and financial reforms has yet to be worked out. There are some promising developments, primarily relating to competitiveness, but the overall pace of reform remains slow, uneven and uncertain.

Carney’s questionable guidance
The greatest policy evolution this year, after the Bank of Japan, was supposed to come from the Bank of England. With ‘the best central banker of our generation’ taking over the institution, a new forward guidance framework was presented this week. Following all the fanfare over the past few months it turned out that less has changed than first met the eye.

The Bank of England decided to communicate that its current policy settings would remain intact at least until the unemployment rate stays above 7% as long as three other conditions are not violated. These so called “knock-outs” referred to the Bank’s inflation forecast, inflation expectations and financial stability. To clarify its intentions the Bank also decided to publish an unemployment rate forecast for the first time, showing that it expects the unemployment threshold to hold until the third quarter of 2016. There are a number of issues with this framework which reduces its potency and increases uncertainty.

First, the outlook for the unemployment rate is uncertain and relies on a number of variables beyond economic growth, most notably the participation rate and productivity. Thus there is a wide variety of potential outcomes. The Bank acknowledges this uncertainty and has given it close to 50% probability that the threshold will be reached by the end of 2015, i.e., three quarters earlier than its baseline forecast. In addition, several leading indicators suggest that the unemployment rate will fall faster than the Bank of England anticipates which further reduces the value of the threshold.

Second, the three ‘knock-outs’ are subjective and lack clarity. The 2.5% inflation forecast knock-out is unlikely to be triggered due to the simple fact that BOE has never had an equivalent inflation forecast above that level. The other two knock-outs (that inflationary expectations should remain contained and that the Bank’s monetary policy should not threaten financial stability) are less transparent and may cause both uncertainty and confusion.

The main problems are that all three knock-outs are highly subjective and at the Monetary Policy Committee’s (MPC) discretion. So we are left with a forward guidance that lacks transparency, is characterised by subjectivity and is centred on an uncertain economic variable to which the Bank has ascribed a questionable forecast. From whatever angle you analyse it, it cannot be described as a robust framework. Adding to the uncertainty is the wide range of views among MPC members that were evident in the minutes from its last meeting.

Notwithstanding our concerns with the BOE’s new framework, we expect the MPC to keep rates low for longer than warranted by the economic recovery. The cyclical upswing in the UK is promising and the economy may reach escape velocity in the not too distant future. However, the last couple of years have illustrated that upswings can peter out quickly. The BOE will want to make sure that does not happen again, suggesting that it will err on the side of accommodation.

Concluding thoughts
The last few months have been dominated by actual or anticipated changes in leadership and strategy at some of the largest central banks in the world.

The changes in leadership are obviously real and will have an impact on policy going forward. Initially this caused ruptures due to market participants’ lack of familiarity with the style and tactics of new leaders. This has been particularly evident in the United Kingdom and Japan and will be an issue in the United States early next year. As market participants become more familiar with the new leaderships and central bank governors and presidents settle in their new roles these ruptures should abate.

The announced strategy shifts have been less meaningful than the market initially thought (with the exception of the Bank of Japan). This is particularly evident for the ECB and BOE, both of which have added some features to an existing framework but without changing that framework in a meaningful way. Despite all the talk of forward guidance and verbal easings, investment decisions will continue to be based on careful analysis of macro fundamentals and market technicals. From this perspective, little has changed for investment professionals such as ourselves.

What central banks have done is to remind us that they will be careful not to threaten the ongoing recovery and that traditional monetary policy instruments will remain accommodative for longer than historical comparisons would suggest. The challenge is to get this message across at a time when i) the Federal Reserve, by far the most powerful central bank in the world, is likely to change its policy mix and begin slow down its QE programme, and ii) the global economy continues to recover. Market participants have already begun to challenge central banks’ dovish resolve, a process that may accelerate if the cyclical data continues to improve. Ironically, this may force central banks to ease.[6]

This back and forth between policymakers and market participants will be challenging to navigate. At the same time, history teaches us that opportunities often materialise when the gap between policy and fundamentals widens.

Prologue is a $2.3 billion macro fixed income manager.

Notes

1. Developed economies lost close to $2 trillion in output in 2008 and 2009. That has finally been recuperated, but output is still $4 trillion short of where it should have been if the financial crisis had not happened.
2. We refer to the core deflator for Personal Consumption Expenditure, the Fed’s favoured measure. Using core CPI gives a similar profile, albeit at a higher growth rate.
3. “In terms of adjusting the threshold, I think that’s something that might happen. If it did happen, it would be to lower it, I’m sure, not to raise it.” Chairman Bernanke during the press conference on 19 June 2013.
4. This pace of increase was twice that following the dot-com bust. During that recession the unemployment rate increased 2.3% over three years.
5. http://www.ecb.int/press/key/date/2013/html/sp130705.en.html
6. BOE’s Mark Carney addressed this in the August press conference when he suggested that “our biggest concern is the possibility that as the recovery gathers pace that there is an unwarranted change in expectations about the pace of the withdrawal of monetary policy stimulus”.