Equity prices riding high as outlook points to a benign Christmas
A major market driver for the current equity rally has been accommodative monetary policy and a benign economic environment of low inflation and steady growth. Global equities, as measured by the All Country World index (includes Developed Markets and Emerging Markets) are up 192% since reaching a post-Global Financial Crisis low in March 2009. Data from Bank of America Merrill Lynch shows that central banks have cut interest rates over 700 times and expanded their balance sheets by $11.4trn since 2008.
Looking forward, central bankers have recently given financial markets more clarity over monetary policy in 2018. The message is that while monetary accommodation would be reduced, it would not be removed quickly. Consider the ECB. Last month, it announced that it would halve its current rate of asset purchases to €30bn per month starting in January 2018. However, the ECB extended its asset purchase program to at least September 2018. In other words, the central bank left QE open-ended and made clear in its forward guidance that interest rate increases would only follow the cessation of asset purchases. This indicates that the earliest the ECB would increase interest rates is late 2018, or, more likely, 2019.
Over in Japan, the government seems set to continue with the easy monetary policy part of Abenomics, due in part to the convincing general election win in October for PM Abe and his ruling Liberal Democratic Party (LDP). In the US, President Trump nominated Jerome Powell to replace Fed Chair Janet Yellen when her term ends in February 2018. Judging from the positive equity market reaction, investors view Mr. Powell as likely to continue the gradual contraction of the Fed’s balance sheet, and removal of monetary stimulus, begun under Janet Yellen.
Central banks have good reason to be cautious in tightening monetary policy, since inflation is still far below the targets of 2% for the Fed, ECB and Bank of Japan (BOJ). The key question for equity and bond markets is how long inflation will remain low enough to allow central bankers to reduce monetary accommodation at such a glacial rate. On this point, there seems little to worry about in the short term as wage gains (a key driver of production costs) continue to remain moderate. Even though the US unemployment rate is down to 4.1%, the lowest level in 16 years, average hourly earnings of production and non-supervisory workers (accounting for 80% of private-sector employment) rose only 2.3% from a year ago, which is actually lower than a 2.6% rate in early 2010 when the job creation cycle started. It could be argued that wages have been anchored at low rates by additional labour supply that is not included in the headline U3 (official) unemployment rate. In October, a record 95.4m of working age (16+ years) were not classified to be in the labour force. Of course, not all these people can work, as some workers may not have the right skills or may be retired. Nevertheless, against a backdrop of increased use of technology to better match job offers with applicants (see our October Investment Outlook), US companies can leverage off labour slack to keep wage rates down.
While policy makers will monitor wage rates, they are likely to focus more on unit labour costs (ULCs are defined as hourly compensation rates deflated by productivity per hour) as a guide to future inflation. That’s because if wage rates are expanding at a faster pace than productivity growth, it may exert cost-push inflationary pressure on output prices. However, US productivity accelerated to a 1.5% annual rate in the third quarter of 2017 from negative rates a year ago, faster than overall compensation per hour growth of 1.4%, so ULCs fell 0.1%. This suggests downward pressure on inflation is likely to persist. For global equities, the longer easy monetary accommodation is sustained, the greater the room there is for equities to rally.
However, not all central banks face a benign inflation outlook. In the UK, productivity growth is lagging behind wage rates, so that unit labour costs have nearly doubled to a 2.3% annual rate since the Brexit vote in June 2016, leading to higher inflation. Since higher inflation has constrained the ability of the Bank of England to sustain easy money policy somewhat, UK equities have lagged behind global peers this year. Moreover, the threat of an anti-business Labour government and adverse Brexit terms are equity risks for 2018/19.