GAM INVESTMENTS: CENTRAL BANK RISK MANAGEMENT

Economic activity is likely to remain resilient in 2019 despite the fact central banks are now being prompted to ease policy. The reason is that final demand is supported by steady income formation in the corporate and household sectors across most advanced economies. In particular, jobs growth and steady increases in real wages are underpinning consumer spending, typically one of the more stable parts of the economy. There are some sources of weakness, notably in world trade and in manufacturing, both of which, it could be argued, are in recession. But the recessions in those sectors do not offset what is happening more broadly in the economy, especially in terms of broader areas such as consumption or services. Accordingly, the economies of the US, Western Europe and Japan are likely to grow modestly over the next few quarters, at or slightly below their trend rates. There is therefore greater fear about global growth than is probably warranted, but central banks, cognisant of downside risks and the fact inflation is below target, are nevertheless prepared to ease in this environment. 

The Federal Reserve (Fed) has signalled it is prepared to cut interest rates as the market has been expecting and as the US president has insisted. That said, the Fed is making its decisions independent of both those factors. It is, of course, aware of market pricing and the political backdrop, but the Fed prefers to make policy based on risk assessment. It prefers to mitigate the worst of two potential risks – recession and further declines in inflation – accepting the possibility that easing now could push the economy to overheat. The Fed is likely to cut rates at its next meeting in July and again before the end of the year. The cumulative cuts this year could be as much as 75 basis points. In doing so, the Fed is applying a risk management approach to central banking. 

Fed easing and indications of the same from Mario Draghi at the European Central Bank’s (ECB) June symposium at Sintra support further gains in risk assets. Global equities are likely to make additional advances, but gains may be modest given high valuations and slowing earnings growth. An inverted yield curve in the US and negative interest rates across Europe could curb the potential for financials and value stocks. Therefore, we believe there will be less potential for rotation in this environment. The steady gainers of the recent past: quality stocks, minimum volatility stocks and information technology, will probably remain in favour. Stocks that perform when the dollar weakens may also do better, given that Fed easing is likely to erode the interest rate attractiveness of the US dollar. Commodity and basic materials sectors, as well as emerging markets, typically do well when the dollar is weakening. 

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