The euro area and the United States are experiencing a persistently low level of inflation which is not symptomatic with the steady decline in unemployment and improvements in economic growth seen during the recent past.
Unemployment in the euro area has been improving steadily from a peak of more than 12 per cent in 2013 to 9.1 per cent in September, marking the lowest level in the last eight years. The euro area economy has been growing steadily, reaching a year-on-year growth rate of 2.3 per cent in the second quarter of 2017, the highest growth rate recorded since the sovereign debt crisis.
More notably in the United States, unemployment fell to just 4.2 per cent in September, which is even lower than pre-2008 levels. Economic growth has also been improving steadily over the last few quarters, reaching an annual growth rate of 2.2 per cent in the second quarter of 2017.
Yet inflation in the euro area has settled in a range of between 1.3 per cent and 1.5 per cent over the last few months. Similarly in the US, inflation has retreated from the high of 1.8 per cent earlier this year to 1.3 per cent in September.
Central Bank involvement has been substantially high since the sub-prime crisis and the sovereign debt crisis in an effort to ease financing conditions, stimulate growth and restore inflation. Policy rates were cut to near-zero or even sub-zero levels, in the case of the euro area. The last quantitative easing programmes saw the size of the Federal Reserve (Fed) balance sheet grow by 1.6 times to $4.5 trillion since 2012, while that of the European Central Bank (ECB) grew by 2.2 times to €4.3 trillion since 2014. However, inflation rates have still not reached the two per cent level targeted by the central banks.
Federal Reserve chair Janet Yellen recognised that the way US inflation has been behaving is somewhat of a ‘mystery’ and that the Federal Open Market Committee (FOMC) cannot clearly indentify the catalyst of such a development. Nevertheless, she stated at the September FOMC meeting that the Fed will remain on the course of hiking rates as the “ongoing strength of the economy will warrant gradual increases”. She also announced that the unwinding of quantitative easing holdings sitting on the Fed’s balance sheet was to start in October. The ECB is not at that stage yet, however, their strategy is also progressing towards a reduction in monetary accommodation.
As they debate the best strategy to exit stimulus and normalise monetary policy, central banks are juggling with another important matter that has, for the first time, only recently been acknowledged in the Fed’s minutes. This is the side effect of the accommodative policies of compressing risk premia and consequently inflating the price of financial assets.
As central banks drove bond yields to historical low levels via their purchase programmes, market volatility decreased to muted levels, while a false sense of security started to develop which pushed investors into riskier asset classes in search for a better return.
The final result: a very low yield environment, very tight credit spreads in investment grade and high yield bond markets, and high price-to-earnings multiples in equity markets. In other words, financial markets are trading at expensive levels when compared to historic levels.
This manoeuvring and shift in discourse by central banks would normally exert downward pressure on valuations in financial markets mainly via two direct channels. As central banks wind down their quantitative easing programmes they are essentially reducing their demand for financial assets. Secondly, higher policy rates set by central banks increases the discount rates applied in valuing financial assets.
Put differently, as rates rise, the opportunity cost of holding a financial instrument increases, and hence, its valuation level must come down. However, despite the impending reversal in monetary policy, market risk premia continued to tighten.
So are we looking at an overvalued market or are the high valuations sustainable in an environment where central banks are tightening monetary policies? While there is no easy answer to this question, the sustainability of high valuations will depend on: (a) how the inflation mystery unfolds, (b) whether the pace of economic growth is maintained or improved, and (c) the finesse with which central banks normalise monetary policies.
While monetary stimulus has played a big role inflating asset prices in the first place, economic growth has to remain in gear for valuations to be sustained when inflation expectations start ticking higher. Central banks at this point have the delicate job of delivering the right policy mix in the size and at the time it is needed in order to achieve a smooth normalisation without allowing inflation to fluctuate too far from target.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
Matthias Busuttil is senior portfolio & investment manager at Curmi & Partners Ltd.