Economic growth influences interest rates and financial markets, and understanding this interplay is important for investors and central banks alike.
The performance of financial markets matters for growth. Interest rates and risk spreads determine the cost of debt capital (borrowings) for the private sector. This includes households, especially mortgages, the corporate sector, and the financial sector, which uses leverage. Equity markets affect the cost of capital and influence household spending via wealth effects. The linkages between real economic growth, economic policy, and asset market performance are complicated, with each variable influencing the others.
These linkages can be quite quick, as we've seen recently. Headlines about the China trade deal can push equities up or down, and changes in Fed policy can be felt in asset markets rapidly but take a bit longer to feed through mortgage rates and household behavior. Growth prospects matter; equity pricing depends heavily on the performance of corporate earnings and on the interest rate at which future earning streams are discounted.
The end of easy money?
In our view, the relationship between the three factors that we saw in 2019 is unlikely to be repeated. We doubt the monetary easing we saw in 2019 can be repeated. Even the optimists on growth don't see a major acceleration. Valuations in key asset markets — notably investment-grade credit — are such that there really isn't much scope for spreads to further narrow. That is not to say that markets will weaken, but if possible spread compression is limited, then risks must be asymmetrically to the downside.
We doubt the monetary easing we saw in 2019 can be repeated.
The pace of gains in risky asset prices over 2019 was quite tightly linked to central bank balance sheets. The Fed's shift in rhetoric at the beginning of the year allowed risky assets to recover from the December 2018 meltdown. Still, the Fed's two rate cuts over the summer didn't do a lot for equities. In September 2019, the S&P 500 Index traded at similar levels to September 2018. The real upward movement in U.S. and European equities came after the ECB re-started its QE program and the Fed began its aggressive open market operations to control short-term rates.
There has been much hand wringing over whether the Fed has effectively resumed QE. But whether it is QE or not, it clearly is a balance sheet expansion and an injection of liquidity into the system. That liquidity found a home in risky asset markets. The balance sheet expansion was, in some sense, a monetary easing.
In the absence of an acceleration in (actual or expected) economic growth stimulated by these actions, we end up with asset markets dependent on financial system leverage that is, in turn, dependent on central bank action. This is a risky configuration — not because there are any binding real constraints on the size of a central bank balance sheet, but because there are important institutional and political constraints.
Monetary policies support financial markets
The Fed wants to reduce its balance sheet and has repeatedly argued that the most recent expansion will be unwound early in 2020. What if the Fed is wrong? It will put us back to a point where the central bank wants to run a tighter policy than the markets can withstand. Implicit in this argument is that it's not really monetary policy that is the problem with global demand growth, but it is monetary policy that is keeping asset prices where they are.
The sluggish pace of global demand growth can be traced to a range of factors including aging demographics and the structural slowdown in China's growth. The household sector has still not recovered from the global financial crisis; that shock has encouraged households to be much more cautious in their savings behavior and in their willingness to take on debt. The pace of technological and the Trump trade war are also playing a role.
In a "normal" cycle, central bank easing pulls economic activity from the future into the present, kick-starting an economic recovery and allowing the central bank to return to a more normal policy stance (and a more normal balance sheet). But what if the recovery doesn't come or is not strong enough? Then a further dose of easing takes place, and the asset markets become a more important channel through which the policy operates.
Until something happens to push global demand growth on a stronger trajectory, high asset returns will only be possible with increasingly accommodative monetary policy.
And what if recovery still doesn't come? That's the position we are in now. The initial trade deal between the United States and China would provide only temporary relief because it would not put the global economy on a sustainably stronger path. Until something happens to push global demand growth on a stronger trajectory, high asset returns will only be possible with increasingly accommodative monetary policy. And there isn't a whole lot of scope for that in 2020.