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When America sneezes, the rest of the world catches a cold. But what happens when the US Federal Reserve (Fed) signals it will keep rates higher for longer while the European Central Bank (ECB) cut rates in June? The truism is a useful one for understanding economic convergence in the US-consumer-led globalisation era, but in a new economic era, its accuracy is beginning to wane. How should investors respond?
Since the late 1990s, when the US cycle turned, the rest of the world generally followed, with a lag. As a result, central banks have tended to follow the Fed’s lead. However, the new economic era — with its greater volatility, higher inflation, and shorter and more frequent cycles — is likely to result in greater cyclical divergence between countries and the need for different central bank responses.
Furthermore, many of the factors that contributed to central bank divergence over the past three decades have now ended or are starting to shift into reverse. For example:
The US consumer no longer determines growth
Then: Global growth used to be an expression of the US consumer — given the US was the dominant buyer of goods from China, Germany and Japan, any weakening in the US consumer naturally flowed through to other economies. As a result, when the US cycle turned, central banks tended to take the Fed’s lead.
Now: Europe, Japan and to a lesser extent, China are increasingly shifting their economic growth models — away from exports towards increased domestic demand and away from manufacturing goods towards services. A more active approach to fiscal policy should also drive domestic cycles to a greater degree.
Deglobalisation and demographic shifts may see inflation patterns diverge
Then: Globalisation made it logical for central banks to converge. In the US-consumer-led globalisation era, if a central bank moved too far away from the Fed, there were significant currency impacts that could hurt competitiveness and feed currency volatility. We can see this tension playing out in Japan, where policymakers are waiting to see clearer signs of real wage improvements before they normalise rates further — although this comes at the expense of currency volatility.
Now: With inflation higher but also more variable between countries, we expect central banks to be focused on adjusting rates to combat specific inflation challenges faced by their economies. Labour markets are structurally tighter due to a shrinking workforce — this can mean trends in domestic services-driven inflation can trump those stemming from tradeable goods, loosening interlinkages.
Central banks are shifting from consensus to independent thinking
Then: Even central banks have to wrestle with groupthink. In a US-consumer-led era, central banks became accustomed to mirroring the Fed’s reaction function.
Now: Desynchronised cycles will force central banks to act independently.
From an asset allocation perspective, higher volatility and dispersion between regions has a number of implications. Increased macroeconomic volatility (Figure 1) creates higher risk but also opportunity, and investors need to think carefully about how they adapt their portfolio approach.
While some of the investment implications of central bank divergence are currently playing out in interest-rate markets, it is also worth looking at the longer-term structural opportunities for portfolios, especially as shorter-term dynamics in interest-rate markets may already be reflected in market pricing.
Interest-rate markets
For some time, we have been expecting desynchronised interest-rate-cutting cycles between the ECB and the Fed. While the US economy continues to expand at a healthy clip, European growth is slowly recovering from a near-recessionary base. Inflation is too high in both regions but has declined more and is closer to target in the eurozone. As a result, the ECB moved to cut rates before the Fed, although it was preceded by other regional banks, including the Riksbank in Sweden and the Swiss National Bank. Investors have positioned for this shift by being long European rates and short US rates, but we believe this is now largely priced in.
Another example of potential central bank divergence is the Bank of Japan. The Japanese yen has been very weak since the start of the year, partly driven by sticky US inflation, which has created a bigger wedge between expected Japanese and US policy rates. The Bank of Japan has likely intervened in currency markets to stabilise the yen, but this is more of a stop-gap measure and it will be under increasing pressure to hike interest rates more aggressively.
Equity markets
Central bank desynchronisation also has implications for equities. There is more room for valuation expansion in Europe, offset by a more robust earnings growth picture in the US. At the moment, these two factors offset each other and thus don’t support a relative preference. Domestically orientated allocations, such as small-cap equities, could offer more portfolio diversification going forward, with more focused exposure to regions behaving differently from each other.
Currency management
Higher currency volatility may strengthen the case for currency risk hedging in portfolios. For investors hedging liabilities, a stronger preference for domestic assets could emerge due to the cost and complexity of hedging and the relative uncertainty around yield premia across countries. A greater reliance on hedging could have implications for corporate financing and portfolio flows if currency trends or volatility begin to have a negative impact on hedged yields.
Diversification and dynamism
More pronounced and desynchronised cycles will lead to greater volatility and more unpredictability in asset prices. However, even if volatility is higher, more dispersion between regions and a growing reliance on domestic drivers may increase the potential for asset allocators to enhance portfolio resilience and reduce overall risk, with the caveat that managing currency volatility can be more complex.
We think this may provide an opportunity for active asset allocation and for macro hedge funds to play a greater role in portfolios.
Looking ahead, we are keeping an eye on the potential that desynchronisation moves to divergence, where one central bank hikes while the other cuts. We think we are unlikely to see the ECB cut while the Fed hikes, but the likelihood of this scenario is growing, especially if European disinflation continues while US inflation data remains sticky.
Looking further out, we would expect greater macro uncertainty to provide increasing active asset allocation and relative-value opportunities between markets.
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