Author: NN Investment Partners
Politics and policymaking can have a significant impact on markets and the economy. These days, investors are faced with quite a large number of important policy and/or political events, potentially having substantial consequences. We discuss a number of these developments in Europe (Spain, ECB), the US (Fed Chair), and Japan (PM Abe’s election victory).
The appointment of a new Fed Chair is imminent and markets are focused. Especially the perceived hawkish beliefs of candidate Taylor are a risk factor for future market evolution.
Catalan parliament declares independence
First of all, the Catalan parliament last Friday voted in favour of independence from Spain. In reaction to this, Spain's Prime Minister Mariano Rajoy assumed direct control of the region, sacked its secessionist government and called a snap regional election for 21 December. The Spanish stock market fell and the government bond spread widened, but both are recovering on Monday morning. Outside Spain the market reaction was muted. Markets still see it as a local issue, which in its current phase seems justified.
ECB announces dovish tapering
The ECB successfully took another step towards the end of its quantitative easing (QE) program last Thursday, as the central bank made a decision on the long-awaited tapering of its asset purchases. From EUR 60 billion per month currently the central bank will reduce its monthly purchases to EUR 30 billion, from January 2018 until at least September 2018. Forward guidance on both asset purchases and policy rates remained unchanged. The program remains open-ended as there is scope for an extension beyond September. The statement that policy rates will remain on hold until well past the end of the QE program was unchanged. At the margin, the outcome was a bit on the dovish side as the total of new asset purchases (9 times EUR 30 billion) was slightly above consensus. We had expected a 6 times EUR 40 billion extension. It was translated by the market in a more than 1% fall in the EUR/USD exchange rate and a 5 basis points lower Bund yield on Thursday.
Within the ECB there was no unanimity about the amount and duration of the extension and the open-ended character in particular, as the German and Dutch central bankers voted against the latter. This is a reflection of the long-standing tension between North and South in the ECB’s Governing Council, which is largely stemming from political influences on the member state representatives in the Council. Obviously, there is also a more philosophical difference in opinion between some of the national central bank governors, but the different political realities and the widely varying “optimal” monetary medicines that the countries in the northern part and the southern part of the Eurozone need remains probably the larger driver behind the heated internal policy debates at the ECB.
Trump almost ready to appoint a new Fed Chair
Another route for political channels to influence global monetary policy conditions is through the appointment of the new Fed Governor by US President Trump. Trump would not be Trump if he was not making some sort of contest of the nomination. While he is keeping the option open to nominate Fed Chair Yellen for a second term, he is also publicly deliberating between two other candidates with very different views about monetary policy. One the one hand there is Jerome Powell, a Fed governor who has voted in favour of every Fed policy decision since 2012. On the other hand we have John Taylor, a Stanford economist and father of the “Taylor Rule”. He is among the Fed’s most vocal critics and believes the current policy trajectory will lead to high inflation.
Since the number of candidates is reduced to three and the White House is said to announce a final decision by 3 November, the market is clearly focused on the topic. Probabilities are hard to assess, but especially the perceived hawkish beliefs of Taylor are a risk factor for future market evolution. The market will assess whether the Fed’s policy normalization path is steered by solid economic arguments or whether it diverges from its optimal path due to politically motivated appointments in the Fed’s leadership. Bear in mind that next to the Fed Chair position, four other members of the Federal Open Market Committee of the Fed will be appointed by Trump over the coming year. Tightening policy on the back of economic strength and rising inflationary pressures will not create too much nervousness in the market. However, an overly hawkish Fed Chairman and a sense of increased political motivation behind Fed appointments still to come might make the market’s comfort more challenging.
We upgrade Japan after the election outcome
Where politics also had a substantial impact on markets is Japan. The snap elections of 22 October led to a landslide victory of the present coalition, thereby removing political uncertainty. Prime Minister Shinzo Abe will most likely be at the wheel until 2021, continuing “Abenomics”. For Bank of Japan governor Kuroda, whose mandate ends in 2018, this is also good news, as he will in all likelihood be reappointed, or, if not, replaced by someone having the same dovish policy philosophy. Following the positive Japanese election outcome, we upgraded Japanese equities from neutral to a small overweight.
The authorities are pursuing a high pressure economy (through fiscal spending and easy monetary policy), given signs of a growing labour shortage and a positive output gap. For the time being, Japan is tackling the tight labour market with an increase in productivity, and given its low levels relative to the US or Germany, there is scope for further improvement. Eventually this will lead to higher wages without impacting corporate profitability. The momentum for next year’s earnings is positive, even if the absolute earnings growth is expected to slow down from 17% this full year to 6% for the full year ending in March 2019.
The monetary policy with yield curve control will keep real bond yields low, supporting valuation metrics. With regard to the latter, within the developed markets Japan offers the highest equity risk premium. Its longer-term return expectations are also above those in the US and even the Eurozone. The valuation argument is also valid if we compare the relative price-to-book ratio with the relative return on equity, which has increased a lot over the past years to levels comparable to the Eurozone.
An element of uncertainty is the negative correlation of the Japanese equity market with the USD/JPY. Japanese equities generally perform well when the yen weakens (see chart). We think that positive developments with regard to the US tax plan and further divergence in monetary policy between the US and Japan could lead to a further weakening of the yen against the US dollar.
Japan equities and the yen are opposite forces
Finally, the risk of our upgrade is primarily linked to its timing. Last Wednesday, the Nikkei Index ended a record 16-day win streak, after setting a fresh 21-year high on Tuesday. The index had climbed in the lead up to the elections on investor expectations that Abe's ruling coalition would win. In addition, according to the latest investor survey by Bank of America/Merrill Lynch, it is an overweight position in investors’ portfolios. Nevertheless, we assess the medium-term prospects sufficiently encouraging to increase our exposure.
