Investors must weigh the risk of rising inflation
Until this week’s trade-related falls, global equity markets had performed strongly this year, advancing as investors moved to discount possible monetary stimulus — and some fiscal expansion in various countries as well.
The FT fund has produced a return of more than 10.7 per cent in the year to date, while having half the money invested in safer bonds and cash to control the risks. The earlier sale of the position in Germany, which is most exposed to the trade war and manufacturing downturn, will help protect the fund a bit more in the sell off. The technology bias of the portfolio has helped, with a strong performance from the fund’s biggest holding which is in the Nasdaq market index.
Now, after China has been branded a currency manipulator by the US, resulting in a market sell-off, investors need to ask themselves will the combined monetary and fiscal stimulus live up to expectations? Could it disappoint or could it overshoot, changing the inflationary picture after years of little or no inflation in the developed world?
President Trump has made his views clear. Despite the current escalation of the trade dispute with China, he wants a higher US stock market ahead of his re-election campaign next year.
The president thinks US money policy has been too tight. When he first set out his views of the need for a change around the end of last year, the Fed’s policy was dangerously tough and was spooking financial markets. It led to a rethink by the central bank, with the stock market warning them of trouble to come and the president bellowing at them that they were wrecking the economy.
The Fed announced an end this autumn to quantitative tightening, the policy of retiring some of the bonds they have bought in. It also stated the central bank was not, after all, going to put up rates, settling for a policy of patience instead. As a result, equity and bond markets took off, and monetary policy started to relax. The latest figures for US money supply (M2) show it growing at a lively 8.7 per cent if you annualise the past three months. It is tempting to think the Fed has done enough.
The president sees it differently. Keen to be re-elected in late 2020, he no doubt realises that what happens now to money and credit will determine economic feelings among voters next year. He wants a substantial rate cut and an end to all quantitative tightening, arguing that the US is paying higher interest rates than competitors and this is unreasonable.
The Fed rhetoric has become more dovish again, pointing to the uncertainties over trade and the continuing low level of inflation as factors in favour of a more relaxed stance. Although there was a 25-basis-point cut last week, this was still not enough for President Trump and he is likely to keep the pressure on chair Jay Powell for more.
Monetary policy elsewhere is subject to more relaxation. The European Central Bank will want to loosen a bit more given the poor growth rate in the eurozone and the manufacturing downturn adversely affecting Germany in particular as a leading exporter.
The Australian Central Bank has cut interest rates from 1.5 to 1 per cent. Even the Bank of England has toned down its rhetoric about rate rises, though it is still running a very tight policy. The Japanese continue with their ultra-low rates and substantial quantitative easing.
US Treasury secretary Steven Mnuchin’s decision to brand China a “currency manipulator” is likely to result in more pressure for further cuts from the White House — and could prompt more stimulus measures from the People’s Bank of China.
Fiscal policy too is on the move. The US led the way with President Trump’s substantial tax cuts, and the cross-party decision to boost spending at the same time. Some fiscal relaxation is possible in the eurozone, where it may be that the area’s fiscal polices are more tolerant of countries like Italy overshooting deficit targets. The new commission and ECB head may also look for ways to reflate the euro economy through EU level spending, or borrowing on an increased scale.
A minority in the markets now worry that all of this could go too far to the point where inflation picks up. In the past three months the gold price has risen, with some seeing that as a canary in the inflation mine.
It is the case that the US economy is still performing quite strongly, and the labour market could see more upward wage pressure as growth continues. The alternative mainstream view is that inflation remains under good control, due to the digital revolution, the ready supply of cheaper labour in many parts of the world, and the continued collective impairment of commercial banks limiting how much they can lend.
The decline of the car industry, under environmental pressure for change of products and governmental pressure to make major changes, limits car loans and has knock-on effects to other industrial sectors.
It is a strange investment universe where so many high-grade bonds now sit on negative interest rates. They can no longer fulfil their historic role of providing a steady income with capital stability. Presumably, people own bonds with negative rates for capital gain, as they expect rates to fall even further. I cannot bring myself to buy Japanese or German government bonds on negative yields and find it odd that the Greek 10-year bond interest rate has fallen below that of the US.
The bond exposure of the FT fund is either cash and near cash to offer that buffer should markets fall, or riskier longer dated inflation-linked paper that might give some protection if inflation does pick up. I have also invested in emerging market sovereign bonds, where the relatively high yields have proved attractive to investors, and where performance has been more like that of the shares in the dummy portfolio as a result.
I continue to run the portfolio in neutral with 50 per cent in shares. Despite the current trade tensions, there looks as though there is a bit more left in this long cycle, all the time assuming reported inflation stays down. If the Fed buckles to the president and cuts too much, I will need to adjust.
Sir John Redwood is chief global strategist for Charles Stanley. The FT Fund is a dummy portfolio intended to demonstrate how investors can use a wide range of ETFs to gain exposure to global stock markets while keeping down the costs of investing. firstname.lastname@example.org