The Chinese punch bowl and the last dance
Philip Saunders – Co-Head of Multi-Asset Growth
William Martin, the then Chairman of the Federal Reserve Board (Fed), commented in a speech to the New York Bankers Association in October 1955, that “the Federal Reserve…is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up”. The fact that the Fed after its recent Federal Open Market Committee (FOMC) meeting was now actually “thinking about removing emergency monetary accommodation” rather than “not even thinking about thinking about raising rates” (10th June 2020) came as an unwelcome surprise to markets and also as a reminder that the Fed still took its role as chaperone seriously. Well, this party has well and truly warmed up. The economic and market rebound from the extreme pandemic uncertainties of last March has surprised the great majority of market participants, including the Fed. Of course, this was largely the result of a huge injection of liquidity and fiscal support and the scale of the global ‘punch bowl’ this time has been truly breath taking. G4 central bank balance sheets alone have been expanded by almost US$10 trillion in just over a year and are up six-fold since 2008 to sustain the illusion of normality.
So, markets are now on notice that the level of support will start to diminish, first in the form of a reduction in the level of quantitative easing (QE) and ultimately increases in official interest rates. The Fed is currently continuing to inject at least US$120 billion a month into the system. The changes will be well telegraphed – possibly as early as August at the annual Jackson Hole policy symposium – and subject to underlying economic conditions at the time. Many investors still bear the scars of the ‘taper tantrum’ in 2013 – the Fed’s previous exercise in ‘soft landing’ markets and the economy. On that occasion, the FOMC, under its then chair Ben Bernanke, had switched abruptly from ‘QE infinity’ in November 2012 to tapering in May 2013. Of course, the Fed will have learnt from this experience and the initial reaction might be more muted this time but notwithstanding, policy sensitivity is surely set to become progressively more acute. Given that financial conditions are even looser than they were in early 2013, the shift in financial conditions that the Fed must catalyse is in some sense even larger.
The Fed appears to have pivoted and we are moving past the point of maximum liquidity
Source: Ninety One, Bloomberg as of 31 May 2021
But peak global liquidity may have been passed already. While market participants remain fixated on what the Fed might do and more importantly when, China’s central bankers have already moved decisively to take away their equivalent of William Martin’s punch bowl and are clearly focused on stabilising the country’s overall debt levels, which remain uncomfortably high. True, China was the only major economy that grew in 2020 and moreover its policymakers used other, more orthodox means than QE to support economic activity, but China’s economy is now twice the size it was at the time of the taper tantrum. In fact, since the Global Financial Crisis, global economic and market ‘mini’ cycles had already become highly correlated to China’s ‘stop go’ credit cycles during the last full cycle. On each occasion, just when emerging market growth more broadly looked to be about to enjoy a sustained cyclical upswing, demand turned down sharply and emerging market assets performed poorly.
So, liquidity tailwinds are in the process of shifting to become headwinds and the key judgement to be made is the extent to which these changes in liquidity conditions at the margin will impact markets. Despite avowedly much better ‘fundamentals’ in a heavily financialised system, we would argue that this could be material and all the more so given that valuations are high across the board indicating that the recovery is ‘in the price’. Credit spreads in high yield bonds are back at their all-time lows and equity risk premia have compressed dramatically, even taking into account the relative ebullience of the earnings rebound. Global growth momentum has peaked and, led by China, is likely to have palpably decelerated by the end of 2021 and into the first half of 2022. Risks are now increasingly skewed to the downside. Certainly, interest rates are still set to remain low and liquidity abundant in an absolute sense, so markets could go on to make higher highs, but it feels right to be at least starting the process of banking profits and moderating risk levels. Within equities this would imply a reduction in reflation trade beneficiaries, including emerging markets, and an increase in reasonably priced ‘quality’. Life at the margin and then more generally could be about to get a lot tougher. A time to remember the salutary tale of ex-Citigroup CEO Chuck Prince who notoriously observed back in July 2007 “when the music stops, in terms of liquidity, things will be complicated, but as long as the music is playing, you’ve got to get up and dance”. He left the company a few months later…