An article discussing key themes that could affect the decisions of central bankers, by our Chief Investment Officer, Markus Stadlmann
I travelled to Frankfurt recently. Before I arrived, a friend of mine had been to a dinner party with European Central Bank President Mario Draghi, who told his favourite joke.
A man needs a heart transplant and after consultation with his doctor is informed: “I can give you the heart of a five-year old boy.”
“Too young”, the patient replies.
“How about that of a forty-year old investment banker?”
“They don’t have a heart.”
“A seventy-five year old central banker?”
“I’ll take it.”, the man concludes.
“But why?”, asks the doctor.
“Because it’s never been used!”
On a serious note, monitoring the thoughts and likely actions of central bankers is a key requirement for investors. We think there are three main developments that could have an effect on the decisions they make (i.e. monetary policy) over the next two years:
Let me elaborate on these three themes briefly.
Long-term economic trends, ranging from population aging to weak productivity growth, in my view are likely to lead to rising inflation.
Productivity measures how much an economy can produce with a given amount of resources (see Explained section). In the UK, productivity growth is stubbornly low. If this remains the case, it could have a negative effect on wages, which would affect the amount people are able to save. Central banks could respond by implementing higher interest rates to encourage saving.
Meanwhile, the trend towards globalisation appears to be at an end. Globalisation has kept inflation at bay over the past three decades as companies have moved production of goods and services to countries with lower wages. But the election of Donald Trump as US president on a promise to protect American jobs as well as the UK vote to leave the European Union (EU) both highlight the growing dissatisfaction with globalisation among voters.
In a recent speech, Bank of England Governor Mark Carney described Brexit as “an example of de-globalisation” and concluded, “on balance, the de-integration effects of Brexit can be expected to be inflationary. At present, the main question concerns the extent to which this adjustment has been brought forward.”
Carney highlighted the interplay between labour markets with inflation. As unemployment has fallen, this has reduced the remaining “spare capacity” within an economy to produce goods and services. Figures released by the Office for National Statistics during September showed UK inflation at a five-year high, with consumer prices 2.9% higher in August compared to the same month in 2016. The figures showed price rises came mainly from imported goods, which have become more expensive due to the fall in the value of sterling following the Brexit vote.
Inflation normally takes several months to show up in the data and, as a result, it could be more dramatic when it does. We have become used to low annual changes in consumer prices and there is a risk that central bankers fail to notice or act with sufficient speed when a significant, long-term shift in inflation takes place.
If the proliferation of cryptocurrencies such as Bitcoin continues, it will have macroeconomic effects. A cryptocurrency is a form of digital-only money that is not issued or managed by any central bank. By way of security, it is protected by encryption to make it difficult to steel or forge, hence the name cryptocurrency.
According to BCA Research’s article, "Bitcoin’s Macro Impact", September 2017, the volume of currency in circulation across the world grew by 5.5% between September 2016 and August 2017. However, the growth rate would be 7% if cryptocurrencies were included in the numbers.
In its September 2017 report, "Central Bank Cryptocurrencies", the Bank for International Settlements, the central bank of central banks, stated, “as it stands, cash is the only means by which the public can hold central bank money”. They concluded that “central banks will have to consider not only consumer preferences for privacy and possible efficiency gains (in terms of payments, clearing and settlement) but also the risks [cryptocurrencies] may entail for the financial system and the wider economy, as well as any implications for monetary policy.”
Currency volatility is the unpredictable movement of exchange rates in the global foreign exchange market. It presents one of the greatest risks to the profits of large companies, most of which are multi-national and earn revenues in different currencies.
Several major currencies, including sterling, the yen, the Swiss franc and the Chinese yuan currently trade far above or below their long-term fair value, in our view. Despite this, investors do not seem to anticipate significant short-term changes in values. By looking at the future value of currencies in foreign exchange markets, it can be inferred that traders expect sterling’s volatility, its value relative to other currencies, to fluctuate by much less in coming months than it did in the aftermath of the EU referendum.
The combination of low expectations for rises in interest rates in the short term, combined with currencies that are trading far away from what appears to be their fair value, means that volatility can be expected in currency markets in the months ahead.
These three factors could affect the profits of both UK and overseas companies. This, in turn, would have implications for investment portfolios hence the need to be aware of and take steps to allow for such possibilities.
Forecasts of future performance are not a reliable guide to actual results in the future, neither is past performance a reliable guide to future performance. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed. Any views expressed are our in-house views at October 2017. Investment markets and conditions can change rapidly and the views expressed should not be taken as statements of fact nor relied upon when making investment decisions. This information may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.
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