In the last two weeks, the US and China announced policy responses that could shape the outlook for the remainder of the year and possibly further ahead. These should have profound consequences not only for the US and Chinese economies but for Europe and other economies. They also have very important implications for the returns of bonds, equities, commodities and foreign exchange for the rest of the year and into the next.
The United States Federal Reserve Bank (Fed) met on September 18 to deliberate on the health of the US economy and surprised many market participants when it announced a half a percentage point reduction in the Federal Funds policy rate, bringing it down to 4.75% after more than a year at 5.25%.
The Fed decision made it clear that it is proactive and certainly not behind the curve, especially when considering the relative strength of the US economy, with the latest readings for Q3 indicating growth of around 3%.
This means that the Fed is opting for a relatively quick normalisation process now, possibly in exchange for less easing later. The implication is that the rates on short-term bonds fall faster now but once they do the work of stimulating the economy, they will then settle at higher rates than would be the case with a less aggressive policy response.
By contrast, smaller and slower rate cuts today would likely require more cuts later, as the economy would be allowed to slow down more. So far, it looks like the European Central Bank (ECB) is in this camp, threading more cautiously, even as inflation is declining and activity surveys are showing less growth and even contraction.
All other things equal, these different policy responses are likely to lead to steeper yield curves in the US compared to Europe, a higher terminal policy rate in the US compared to Europe and a wider interest rate spread differential of US bonds versus their European counterparts. The US dollar might also be supported over the medium term.
Another effect of a more aggressive Fed-style policy response is that lending rates fall, financial conditions improve and equity and house prices increase faster and work to the economy through the wealth effect. Ultimately, the US economy might achieve the coveted soft-landing where growth slows down cyclically, bringing inflation near the 2% target, while avoiding recession. Europe might find it more difficult to avoid a recession if the policy response is not strong enough.
A few days after the Fed decision, China announced a coordinated stimulus package that was bolder than what was being priced in by markets. The September Politburo meeting, which meets regularly to decide on the policies of the Chinese Communist Party, announced forceful reserve requirement ratio and rate cuts, an enhancement of counter-cyclical adjustment of fiscal and monetary policy, the issuance of ultra-long Chinese Government Bonds (CGBs) and local government bonds to finance government investment and other measures to stabilise the property market and boost private consumption.
Geopolitical risks increased again with the re-escalation of the Middle East conflict- Colin Attard
It has been reported that China will issue an additional RMB2 trillion special CGB this year, equivalent to around 1.7% of GDP, that among other things, will go towards financing subsidies of consumer goods and giving cash allowances to families. This is expected to have a large multiplier effect. In addition, other reports indicated that RMB 1 trillion would be injected by the Chinese government into the capital of the large state banks, again through the issuance of CGBs.
China’s policy response aims to achieve the 5% growth target for this year, which was becoming increasingly dubious as the year unfolded as the property market’s weakness continued to spill over into private consumption.
However, it also has other effects. It propels Chinese equity markets higher, soaring more than 15% in a week, it lifts broad emerging market equity indices of which China has a large weight, it boosts commodity prices such as copper, it strengthens commodity currencies such as the Australian dollar and it also had the effect of boosting the outlook on European companies exposed to China.
Nevertheless, some tail risks remain. Geopolitical risks increased again with the re-escalation of the Middle East conflict, investors typically turn cautious in the run-up to a US election and China’s policy responses, while necessary, may not be sufficient to turn the economy around on a more sustainable basis. Nevertheless, these policy announcements offer strong support to the global economy and equity markets as we enter the last quarter of the year.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.
Colin Attard is head investment strategy at Curmi and Partners Ltd.