Both the Federal Reserve (Fed) and the European Central Bank (ECB) agreed on the fact that benign global economic growth is in place, in addition to the relative upward moves in inflation from the previous stagnant phase. Indeed, this was the common factor communicated in the latest minutes published by the two prominent Central Banks. However, the risk assessments do diverge, and thus, it is fascinating to assess these major possible risk factors.
The Fed seems to transmit more optimism with an upward revision in growth, given the latest accommodative financial conditions, the enacted tax legislation, as well as the improved global economic growth. Technically, such sources of support should trigger both household and business spending and will be a strong source for a supporting economic momentum.
Just as a reminder: slightly over two thirds of GDP in the US is attributed to consumer spending. This form of feel good factor amongst US consumers is a gauge of how companies will adjust their utilisation capacity to increase productivity, given the increased demand.
Therefore, in reality, it is a spiral effect, which will ultimately support the view of economic growth momentum.
The more interesting takeaways from the last Fed minutes are the highlighted risks that can negatively affect the path towards sustained growth. The first risk is the elevated asset valuations, which despite being highlighted in previous minutes, it remains an important factor to monitor. The rationale behind the said risk should be seen from a ‘wealth effect’ perspective. As asset valuations increase, households become wealthier, which in turn will possibly trigger a less conservative approach in managing their finances. The second risk assessment, which is also tight to the ‘wealth effect’ factor, is the increased debt pile by both households and non-financial corporations.
In my view, both are concerning risk factors when one considers the recent spike in volatility, and how the possible sustained period of volatility will affect the ‘wealth-effect’ preposition and the increased debt load vis-à-vis the recent movements in yields, which ultimately translate into higher borrowing costs.
Likewise, the ECB minutes are in consensus that economic growth should be sustained, while it seemed less concerned about inflation levels, despite the yet minimal movement in wage growth within the eurozone area.
As opposed to the Fed, the ECB’s risk assessment diverge primarily on two fronts. Firstly, the ECB is less worried about the asset valuation preposition, and it believes that the current valuations are still within acceptable bands of financial stability. In reality, such argument is in line with yet more attractive valuation levels when compared to US assets, which over the past years have outperformed their European counterparts remarkably.
The second highlighted and interesting risk is the recent movement in the exchange rate. In my view, this is the riskiest bit and should be monitored and given certain importance. Indeed, a further strengthening in the Euro threatens and complicates the path towards the inflation target. In addition, it also threatens the current economic momentum. In all fairness, the current global growth momentum is a synchronised one, and all regions are contributing. In this regard, imbalances through currency movements might hinder the growth path. Now, this is my personal view, but in reality, no country is experiencing strong domestic demand that is sustainable enough for growth.
Ultimately, despite both Central Banks having different views on risks, they both believe that these might hinder economic growth. Going forward, I believe that this will be a volatile year for markets, mainly triggered by the trajectory of rate hikes, which in turn will also affect the currency market such as the EURUSD currency pair, which should depreciate when compared to the rally experienced in 2017.
In turn, this is one of the reasons why some investment managers are favouring European assets. That said, future ECB decisions might also be a factor of movement in asset prices, in addition to political uncertainties, such as the Italian elections on Sunday. Fasten your seatbelts, the months ahead are interesting ones.
Disclaimer
This article was issued by Jordan Portelli, investment manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.