These days it is easy to be cynical. Writing this on the eve of a U.S. government shutdown, it seems that our leaders and institutions too often disappoint us. Perhaps the truth about our leaders and institutions was always oversold, yet we chose to believe differently. As humans, we are drawn to a good narrative. In particular, the narratives told by those in power are essential in defining reality by providing meaning (although not necessarily the truth) to our social arrangements. The powerful craft narratives to justify their influence while the rest follow to improve their lot.
In the case of the central bankers, we should have taken them at their word. They proved more powerful than anticipated as the narrative they developed has shaped the reality for the market. Investors could have done better by following their lead and buying into their story. The Federal Reserve sought to provide liquidity for as long as was necessary to repair the damage done by the financial crisis. They indicated that they were less worried about the aftershocks of an overheating economy and inflation than they were deflation. Both Ben Bernanke and Janet Yellen promised to let the economy run hot. It took a while to ignite the pilot, but it appears to have finally lit. Along the way, it was easy and costly to doubt their commitment.
The European Central Bank (ECB) was no different. Mario Draghi pledged to do whatever it takes to restore confidence in his broken banking system. True to his word, he financed the entire European problem loan book for an extended term. He is reluctantly removing stimulus as the European economy gradually recovers. He is pressing less aggressively on the accelerator but will continue to drag his feet. You can count on it.
Even the Bank of Japan (BOJ), which should remain guarded against prematurely removing unconventional policies, is toying with the idea of returning rate setting to Mr. Market. Japan is best able to assess the risks of “pushing on a string” having pushed on one for over 20 years. The process to remove accommodation will take a long time. The BOJ may tap the brake but will continue to propel the economy forward.
Central banks may be adept at managing the overheating phase of an economic cycle. Arthur Burns and Paul Volcker may humbly disagree, however. The Bankers appear justified in their caution this cycle given the difficulties in generating inflation. The forces of deflation are still present. The policymakers are confident, perhaps overconfident, that they have the tools to manage faster economic growth and inflation without incurring risk. They are less sure that they are prepared to deal with the downside should it happen to occur before the normalization of interest rates and their balance sheets.
It is unfair to criticize central banks for providing the liquidity that they did during the financial crisis. They are intended to be the lender of last resort. It is quite another thing for them to use their balance sheet to ensure bull markets. They have played their hand too long and need to find a gracious exit. Lower interest rates and easy credit have provided a solid backdrop to restoring confidence and growth. It has also sown the seeds of the next crisis by encouraging more debt.
The cyclical outlook for 2018 indicates risks of higher inflation and interest rates globally against a backdrop of increased investment demand and hiring. This has also been the initial forecast at the start of every year since the financial crisis. Perhaps tax cuts will finally encourage business investment in capital and equipment rather than dividends and buybacks. We remain skeptical.
The global economy gained momentum in the second half of 2017 despite a high degree of skepticism. For the United States, hurricanes, floods and fires proved stimulative. For Europe, expectations of political instability proved overblown. Asian fears for a significant slowdown in China once again proved premature, while animal spirits in Japan awoke from a long hibernation.
With stock markets and economies clearly in synch, the path of interest rates needs to adjust upward. If economies have genuinely turned the corner, it is no longer prudent to maintain zero interest rate policies. The Federal Reserve has already started to normalize interest rates through gradually raising interest rates and reducing the size of their balance sheet. The ECB has cut the size of their bond purchases and will continue to taper. They will be reluctant to raise interest rates given the impact it would have on the euro. Japan will be the slowest to adjust its interest rate and balance sheet policies fearing a return to the lost decades.
In our view, we are late in the economic cycle globally. There may not be a serious risk of recession in 2018, but tightening financial conditions against a highly levered system will gradually increase the risk as we move into 2019. Financial markets have priced in most of the good news and discounted it at extremely low interest rates. It will not be difficult to disappoint. There is speculation in everything from bonds to bitcoin. A gradual increase in interest rates might act to stall rallies in risky assets, while a rapid increase in interest rates would likely kill it. Now that the consensus is forecasting high returns maybe we can get the lower returns that we believe are consistent with a global economy still on life support.
The narrative spun by the central bankers is increasingly strained. Facts on the ground suggest a truth at odds with their decade’s old policies. The power of the central bankers to shape market reality is slowly ebbing away. The remaining question is whether the end of this story will have a happy ending.
 An imaginary investor devised by Benjamin Graham and introduced in his 1949 book “The Intelligent Investor.”
©2018 Northwest Passage Capital Advisors LLC. All rights reserved.
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