Policy divergence won't derail expansion (Archived)

By John Sparks, BNY Mellon IM North America

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The long-anticipated normalisation of monetary policy by the Federal Reserve and Bank of England could finally arrive in 2015. But BNY Mellon chief economist Richard Hoey and chief global markets strategist Jack Malvey say policy divergence among developed country central banks will be only one force affecting the global economy and financial markets in 2015.

For the past three years, global economic growth has advanced slowly and unevenly, averaging nearly 3%, but with some regions such as the eurozone performing less strongly than others. While that uneven pattern of growth is likely to continue in 2015, BNY Mellon chief economist Richard Hoey expects somewhat stronger overall growth as the expansion of the US and global economies accelerates and central banks in the US and UK normalise policy.

“Stimulative monetary policies have generated only sluggish growth so far in this expansion due to a combination of drags from fiscal tightening, private sector deleveraging and restrictive financial regulation,” he says. “Substantial fiscal tightening has already occurred in most developed countries and is likely to prove less of a drag over the next several years. Debt burdens remain high in Europe and China, but US households have substantially reduced their debt.” Hoey expects US real GDP growth of about 3% and real growth plus inflation of about 5% in the US for the next several years.

Like many capital market professionals, Hoey identifies the divergence of monetary policy among central banks in developed countries as a defining feature of the global economy in 2015, with the European Central Bank (ECB) and the Bank of Japan (BoJ) maintaining easy policies while the Federal Reserve and the Bank of England (BoE) may gradually normalise interest rates by tightening policy.

Policy normalisation, though, will likely be only one factor affecting financial markets. For equities, chief global markets strategist Jack Malvey says policy divergence means relatively little. “The central bank theme has been overdone in capital market coverage and media. Historically, some banks are always tightening while others are loosening. Capital markets will be driven by many factors,” says Malvey.

Malvey says corporate earnings will be among the key drivers of equity market performance in 2015 and he expects them to rise by 6 to 8%. Merger and acquisition activity, abetted partly by hedge funds and partly by companies doing strategic acquisitions, is also likely to push equity valuations higher. “The cost of debt capital is low and should remain low, so it’s a fairly ideal time to make acquisitions because both equity and debt financing are available and relatively inexpensive,” he says.

Another factor in equities’ favour in 2015 may be the relatively modest opportunities offered by other asset classes. “Ten-year Treasuries at 2.10% or 2.50% are unappealing on an after-tax basis,” says Malvey. “Municipal bonds offering effective yields of 2% or 3% are also unappealing compared to the potential return from good, strong companies paying dividends.” Despite the positives for equities, Malvey expects markets to turn more volatile than they have been in the past three years. “A typical characteristic of the middle of the business cycle is that markets become increasingly choppy. Markets gave a taste of that when they turned volatile in October 2014,” he says. Malvey also notes that equity market performance will naturally vary across the world, with some emerging markets likely to fare well and the eurozone likely to lag.

Central bank policy will play more of a role for fixed income markets than for equities. “Fixed income securities in 2015 will have impetus from central banks pushing for higher rates and demand from some investors for high-quality securities that have even a meagre coupon,” says Malvey. “By the end of 2015, 10-year Treasuries could be in the range of 2.50%-3.25%.” We feel fairly comfortable that the federal funds rate will be higher at the end of 2015 than at the beginning of 2014. It’ll stop somewhere between 2% and 3% over the course of the next two to three years, depending on the actual vigour of the US economy.” Hoey also expects interest rate normalisation to be a multiyear process in developed countries, gradual enough to not disrupt sustained economic expansion. 

The speed with which interest rates rise will be determined partly by inflation expectations. Hoey sees the global economy beginning 2015 with underlying inflation below the targets set by all four of the G4 central banks. “Our expectation is that underlying inflation will rise to or above target over the coming years in both the US and UK. The underlying inflation rate should drift higher in both Japan and Europe but remain below target for the next several years.” 

Foreign exchange is another area affected by changes in monetary policy. Hoey and Malvey both expect the US dollar to strengthen over the coming year. “Monetary policy divergence will likely contribute to the basic dollar uptrend and be accompanied by widening interest rate spreads as US and UK rates rise and the ECB and BoJ’s balance sheets grow relative to those of the Fed and the BoE,” says Hoey. “Currency weakness in countries with weak growth and currency strength in countries with strong growth should help rebalance global growth and inflation. The US dollar should also benefit from the continuing rise in US energy production. These factors help explain the dollar’s rise in 2014 and they should contribute to a further rise in 2015.”

Another effect of the stronger dollar, Malvey notes, is that earnings of US multinationals will be somewhat dampened by the stronger dollar. “A stronger dollar will also slow US export growth while hopefully stimulating European economies,” he adds. “Meanwhile, Japan will continue managing the yen to encourage exports.”

Even more difficult to anticipate, says Malvey, will be the geopolitical risks that may affect markets in 2015. “Neither the rise of the Islamic State (IS), the conflict between Russia and Ukraine nor the spread of Ebola were forecast at the beginning of 2014, but each exerted a pull on markets during the year that followed.”