- Macro Strategist
United Kingdom, Institutional
Change
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One of the conclusions of our structural work, highlighted in my 2023 global economic outlook, is that macro-economic cycles are likely to be more extreme, frequent and compressed, as central banks become an additional source, rather than a compressor, of volatility. A key macro implication of that finding is the likely greater cyclical divergence between countries and the need for different central bank responses.
The market, however, appears to disagree and is currently priced for continued cyclical convergence (Figure 1), which assumes that the historical pattern that has formed since the late 1990s will remain in place.
Figure 1
Despite the current market pricing, we think that many of the factors that contributed to the central bank convergence over the past three decades have now ended or started to shift into reverse. As a result, we expect the interlinkages between countries, central bank policies and market pricing to change, creating potentially attractive opportunities for active portfolio management and security selection.
Our view challenges many of the inherent assumptions that held true over the last decades, notably:
- Global growth has been an expression of the US consumer — Global growth has converged significantly since the late 1990s, with the forming of a clear supply chain. The US has been the dominant buyer of consumer goods from China as well as capital goods from Germany and Japan. As a result, when the US cycle turned, the rest of the world generally followed with a lag. It also meant that central banks naturally took the US Federal Reserve’s (Fed’s) lead. This, however, is likely to change, as our work suggests that we are moving back to an environment where the growth model of the large economic players, particularly Europe, Japan and China, is shifting away from exports to increased domestic demand. And there are clear signs that the services sector in each of these regions, rather than manufacturing, is now leading growth.
- Capital flows resulting from globalisation have forced central bank policy convergence — In the US-consumer-led globalisation era, if a central bank moved too far away from the Fed, the currency appreciated and effectively acted as a drag on export growth. Going forward, we think monetary authorities’ attitude to currency strength will change when inflation is high rather than perceived as dangerously low. By way of a recent example, the Swiss National Bank fully exited negative interest rates in mid-2022 and, since then, has allowed the Swiss franc to strengthen versus a broad basket of developed market currencies to combat resurgent inflation. While, at the time of writing, the Bank of Japan is still sticking to its negative-rate policy, we think it is in the process of pivoting to tighter policy (potentially dropping the negative-rate policy and yield-curve control) as “sustainable” inflationary pressures continue to build in Japan.
- Lack of independent thinking among central banks — Major central banks outside the US have become used to following the Fed’s lead and mirroring the Fed’s reaction function. This may not be an issue in a low-inflation era, but it will become much more difficult to hide within the “herd” in today’s world, especially when some countries’ inflation is running high. Europe, for instance, is far less impacted than the US by the recent turmoil in the banking sector, and the European Central Bank (ECB) in particular has more ground to cover before it is ready to pause rate hikes. By contrast, late-cycle dynamics for the US economy suggest to us that the Fed is near the end of its hiking cycle.
Figure 2 highlights an example of this growing divergence. It shows that the recent acceleration in global money supply —defined as cash and redeemable shorter-term deposits (M2) — across China, Europe and Japan has more than offset the contraction in the US.
Figure 2
In summary, the market’s assumption of cyclical convergence could be challenged.
Global activity indicators for developed markets suggest near-term resilience but we expect signs of divergence to emerge, with the US no longer setting the pace. Following the global financial crisis, monetary authorities across several countries effectively mimicked the Fed and, to a lesser extent, the ECB, even though the source of their problems was different. As a result, those countries — typically small, open economies — ended up with higher inflation relative to the US and the euro area. In a low global inflation world, these price pressures pushed up housing costs and household leverage. These adverse effects of monetary policy convergence mattered less on a global level, as these were small economies.
As long as the US banking crisis doesn’t morph into a global banking problem, other countries quickly following the Fed’s response to the current problem will once again face consequences: to name one, they will be more likely to embed high medium-term inflation. That is why I think something is wrong in the current pricing on a cross-market basis. Either the current symmetrical front-end pricing across markets, which assumes that central banks will automatically follow a potential Fed cut, is wrong or, if it is right and central banks once again take the lead from the Fed’s policy actions, this unwarranted policy convergence could result in higher risk premia in the long end of yield curves in various countries. The current pricing for the long end of their curves is out of kilter given the scale of the implications, with the potential for significant underperformance versus the US across a range of assets. Something has to give.
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