During his time as the chairman of the US Federal Reserve, Ben Bernanke was notable for taking bold, often controversial decisions with immeasurable calm. ‘Part of this game is confidence,’ he wrote in his memoir Courage to Act. ‘Looking clueless and uncertain does not help.’For a world paralysed by fear, a steady hand at the Fed was a huge reassurance. Panic was arrested and gradual recovery soon took hold.
Today, things could not be more different. Central banks seem to have lost their way, their nerve or both. Take Japan: in 2013, the Bank of Japan declared that in order to breathe life into its economy, it would undertake aggressive quantitative easing (purchasing of bonds and equities) to achieve a two per cent inflation rate by 2016. That goal is likely to be missed by a wide margin. Yet the BOJ appears apathetic, in a hurry neither to increase the size of its QE programme nor to reinforce it with other measures. Bold and decisive this is not.
Across the Pacific, the US Fed also seems afflicted by a crisis of confidence. Having spent much of the past year making the case for a rate increase before the end of 2015, volatile markets and softening commodity prices seem to be confounding Janet Yellen’s long-standing plans. With the road to rate increases becoming increasingly uncertain, markets are having to interpret the cacophony of conflicting predictions by the various members of the Fed’s policy-setting committee.
In London, Governor Carney remains an enigma. Over the past two years he has often confused the markets with contradictory messages about the future. Perhaps this more opportunistic central banker does not like to have his hands tied by grand plans. Nevertheless, in a world of increasing uncertainty, his lack of vision is unnerving.
This pusillanimity among policymakers has some grounds. Economic relationships that have guided policy for much of the post-war era increasingly appear broken or disrupted. Take the Phillips Curve — the inverse link between unemployment and inflation — which for decades guided central banks in their calibration of interest rates. In the aftermath of the financial crisis, the Phillips Curve appears to have significantly weakened. Employment levels are high across much of the developed world, yet inflation is mostly absent.
Or take the positive relationship between corporate profits and investment, another salient feature of market-based economies. Increasing profits typically lead to higher investment spending. Yet in recent years, investment levels have stagnated even though profit margins remain at peak levels.
Then again, take the relationship between real interest rates and real growth rates, which usually match each other when the economy is in balance. Over the last decade, real interest rates have been on a downward march, regardless of growth prospects. While some of this could be blamed on central bank repression of interest rates, the size of the downward move suggests bigger forces at play: an imbalance in the world’s savings and investments that is unlikely to fade.
With so many economic relationships turned on their heads, it’s no wonder policymakers are struggling to chart a convincing course. This rudderless environment can be confounding for investors. What should they watch for?
First, with the global policy toolkit apparently empty, tail risks are increasing. A sluggish economy can easily be knocked off course by external shocks. The ongoing rebalancing in China could accelerate, leading to a downward global lurch. With interest rates at zero and fiscal policy exhausted, how will policymakers stabilise any coming downturn? Will cash rates go substantially below zero to stimulate growth and investment? Or will the economy be left to self-adjust, a commonplace occurrence before the creation of the modern-day central bank? Either course could deeply unsettle financial markets.
Second, inflation seems to have escaped the grasp of central-bank influence. Global forces and technological progress are increasingly disrupting local economic cycles, raising questions over the relevance of the rigid inflation targets adhered to by most central banks. With global inflation on a steady downward trajectory, the risks to profits from a sluggish and indebted world are growing.
Opportunities in this uncertain world are necessarily more long-term in nature. The steady decline in real interest rates over the past decade is likely to persist. With it, the wedge between growth and interest rates is likely to continue to benefit risk assets, particularly those that are geared towards longer-term growth trends — like demographic change and technological progress.
Investors should seek out equities geared to a world in which economic power will be shifting to an ageing consumer and a growing middle class in developing countries. Harnessing such trends while incorporating the rise of disruptive technologies and business models could provide useful ballast to the uncertainty.
Over the next years, investors will need to steady their nerve and keep their eyes firmly on the distant horizon. The nearer horizon is rather too blurred.
Subitha Subramaniam is chief economist of Sarasin & Partners.