Macro Insight
Weaning the Global Economy Off Stimulus
 
 

Macro Insight

Weaning the Global Economy Off Stimulus

 

The global economy has been under intensive care since 2008. All three major developed markets—the U.S., Europe and Japan—have maintained low interest rates and received liquidity injections from their central banks to support their ailing economies over the past several years. The serum: Quantitative easing (QE). In late 2014, the U.S. withdrew its QE stimulus programme and followed this later with interest rate hikes. Europe and Japan may soon follow, making this a good time to check on the patients.

Due for a check-up

Aside from a couple of complications—stubbornly low inflation in Japan and negative bank deposit rates outside the U.S.—the prognosis is good. All three regions are logging positive growth in real terms. The U.S. and Japan are operating at near-full employment, and Europe’s 8% rate of unemployment is also at or below historical norms.1 (Display 1)

PMI indicators are also strengthening, and inflation in the U.S. is starting to pick up. Ongoing QE in Europe and Japan is acting to stimulate demand for goods and services, business investment and consumer spending, whilst keeping yields low. On balance, this is a good environment for risk assets.

 

Display 1: Check-up: Vital signs of major economies
 
 
 
 

Source: Bloomberg. GDP data is real year-over-year growth. For the US and Europe, data is Q1 2017; for Japan, it is Q4 2016. Unemployment data as of April 2017 for the US; for Europe and Japan it is March 2017. Inflation data as of March 2017 for the US and Europe; for Japan, it is April 2017. The central bank deposit rate and quantitative easing status are as of May 2017.

 

 

Easy does it

Market participants have taken the Federal Reserves (Fed) willingness to raise rates as a credible sign of confidence in the U.S. economy. In fact, from January 2010-March 2017, market performance was best when real interest rates rose in tandem with rising inflation expectations. During such periods, the S&P 500 rose an average of 5.4% in the two-month period surrounding a rate hike. When rates fell due to falling inflation expectations, equities fell by an average of -0.3%. (Display 2). It appears that rate hikes are not disruptive if they are delivered in gradual doses that are in line with prevailing economic conditions.

 

Display 2: Perfect pair: Inflation expectations and real rates rise together
 
 
 
 

Source: Bloomberg (30 November 2009 through 31 March 2017). Real rates are measured by the 10-year real yields and the inflation expectations is measured by the 10-year breakeven movement. This index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See disclosure section for index definitions.

 

 

Relapse risk

At some point, interest rates become a hurdle for equities. In principle, future equity earnings are discounted by real rates to arrive at current valuations. All else being equal, higher discount rates translate into lower present values. If rates increase too quickly, equities will fall in value.

The reason doctors have careful protocols for withdrawing medication is that the weaning process poses a risk to the patient. There is often a risk of relapse, particularly if the withdrawal is too abrupt or too early. Similarly, sharply rising rates tend to be negative for risk assets and the overall economy. The Bank of Japan’s (BoJ) decision to lift rates in August 2000, while economic conditions were still uncertain, is often used as an example of this relapse risk (Display 3).

In the U.S., where QE life support was removed gently and gradually, the economy managed to get back on its feet. Last year, when the Fed governors mentioned the prospect of raising target interest rates, the market dropped significantly. Arguably, the economy was too weak too endure the Fed’s tighter policy. This year, that has reversed: Market participants now seem to think that the economy no longer needs coddling.

 

Display 3: Economic health warning: Hazards of removing stimulus prematurely
 
 
 
 

Source: Bloomberg data as of 31 December 1998 to 31 December 2002. The Nikkei 225 index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See disclosure section for index definitions.

 

 

Co-dependent behaviour

With QE still in full swing in Europe and in Japan, U.S. interest rates cannot rise too much without consequences. Should U.S. bond yields get too far ahead of their counterparts, European and Japanese investors would sell bonds to their local central bank and buy cheaper U.S. bonds, which would eventually depress the yield of U.S. bonds. It is as though the U.S.—though no longer on QE life support—shares a hospital ward with Europe and Japan, inhaling the same QE-infused air as its two roommates.

So, it is somewhat misleading to look at U.S. bond yields as representing market sentiment. They are only partially representative, because they are being artificially depressed by QE in Europe and Japan.

Lingering side effect: Bloated balance sheets

The Fed’s balance sheet, currently at about $4.5 trillion2, is still well in excess of its historical average of $700 billion.3 Bringing it back to a more normal level would require that the Fed stop buying bonds. Since there is no sign of the U.S. government halting its selling of bonds, this should reduce the net demand for bonds and put upward pressure on interest rates. So whilst it has removed QE, the Fed still has a significant amount of normalisation to achieve before it can say that the U.S. has fully recovered from the financial crisis of 2008.

The U.S. balance sheet is now 24% of Gross Domestic Product (GDP) and Europe’s is 32%—both very high numbers. Japan’s balanced sheet has expanded dramatically and is now a staggering 83% of their GDP (Display 4). Together, these add up to significant extraordinary measures that remain in effect while the global economy is getting back to normal.

 

Display 4: Japan’s balance sheet: The big gorilla
 
 
 
 

Source: Bloomberg data as of 31 December 2004 - 31 December 2016.

 

 

Europe: Election fever has subsided

Macron’s win in the French elections neutralised a potential source of volatility. Indeed, even before his election victory, it appeared that investors’ relief in the reduction of political risk was palpable. After the first round of the elections, the euro immediately strengthened against the dollar. This would usually be a negative for equities, yet European equities climbed higher (Display 5). Clearly, investors are now focused on a strengthening European economy and positive earnings expectations. Bond deals are starting to pick up, but there’s a limit to how much bond issuance can increase while QE is in place.

We expect the European Central Bank (ECB) will soon be under considerable pressure to start removing its extraordinary monetary policies. It could choose to raise rates, which are currently negative. Banks need positive interest rates to earn profits, so a higher rate would likely boost banks’ income, tighten monetary policy and still preserve the ECB’s ability to buy bonds if spreads start widening.

 

Display 5: Relief rally after the first round of the French elections
 
 
 
 

Source: Bloomberg data as of 5 May 2017. This index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See disclosure section for index definitions.

 

 

June 8: A temperature check

The 8 June 2017 ECB meeting will be critical. So far, Mario Draghi, the ECB’s president, has not provided any obvious indication of a change in monetary policy, despite the improving European economic data. However, with the French election out of the way and 2018 only months away, we think there is a strong chance that he will indicate whether he intends to tighten interest rates and taper QE.

If Draghi does make a strong announcement on 8 June, we will be closely watching the market’s reaction. If he is relatively hawkish and the market goes up—as it seems to be doing in the face of Fed interest rate increases—this suggests that the market is confirming European economic strength. On the other hand, if the market starts becoming jittery, that would suggest that rising interest rates are burdening the economy by making business more costly.

Japan: Could be pressured to withdraw stimulus

The third patient in the hospital ward is Japan. The Fed seems to think the U.S. economy is returning to significant growth. If Europe and Japan also start growing, it is going to be hard for the Bank of Japan to maintain an aggressive QE programme. At some point, they’re also going to have to start withdrawing QE. We plan to keep an eye on how quickly that is likely to occur and whether there are signs of a relapse.

Potential flare-up: Fiscal stimulus

The favourable outlook is dependent on the central banks removing these extraordinary measures in a very slow, measured fashion. Although that is certainly their intention, there may be obstacles, such as potentially extraordinary fiscal stimulus coming in the U.S. via a massive infrastructure building programme or very substantial tax cuts. Too much stimulus could push the temperature up and cause the patient to relapse—it would create excess demand greater than the economy can absorb with low levels of productivity, leading to inflation. This could change the diagnosis substantially.

Currently, the U.S. headline inflation rate is at 2.4%, with Europe at 1.6% and Japan at negative 0.1%.4 We do not see inflationary pressures in Europe, and evidence suggests that it is not likely to pick up strongly by the end of the year. We’ve also seen a dramatic fall in the price of oil recently, which is favourable for inflation outlooks and likely to enable the G3 central banks to remain on a moderate path for removing stimulus.

Central banks seem intent on removing monetary stimulus in a gradual and measured way. If markets are allowed to behave on their own, particularly while oil prices drop, the resulting outlook for equities should be quite favourable.

China: A positive contributor

Investors see China’s growth as a government policy decision: If growth slows too much, the government simply channels money to its preferred sectors. However, China has recently started allowing “zombie companies” to go bankrupt while also clamping down on some over-levered wealth management products.

These policies have made some investors nervous. In our view, these are positive developments, though they could temporarily depress the market. There’s an important distinction between the Chinese government losing control of the economy—as they did in 2015—and their current attempts to address specific weaknesses in the economy.

We certainly do not see China as an imminent threat to the recovery of the global economy. We expect to see continued growth in China, with a rebound in industrial metals that have fallen on sentiment-related decline.

Modern treatment seems to be working

Post-war, we would have to go back to the Great Depression to find a comparable banking crisis to that which we experienced in 2008. In that crisis, the rate hike of 1937 is instructive. Responding to what is now an old fashioned view of equilibrium, the Fed felt that it had to raise rates while the economy was still weak. This reduced liquidity in the system, plunging the economy into the depths of the Depression.

Today’s scenario is very different. We believe global markets’ positive reaction to recent Fed rate hikes indicates that the global economy really is recovering. We will be watching the ECB closely on 8 June for more indicators. Stay tuned for our next prognosis.

 

 
Managing Director
 
 

1 Source: Tradingeconomics.com; Eurostat. “Unemployment Rate in the Euro Area averaged 9.78% from 1995 until 2017, reaching an all-time high of 12.10% in March of 2013 and a record low of 7.30% in November of 2007”.

2 Source: Quarterly Report of Federal Reserve Balance Sheet Developments, March 2017. https://www.federalreserve.gov/monetarypolicy/files/quarterly_balance_sheet_developments_report_201703.pdf as of 18 May 2017.

3 Source: Board of Governors of the Federal Reserve System. https://www.federalreserve.gov/monetarypolicy.htm as of 18 May 2017.

4 Source: Bloomberg. Inflation data as of March 2017 for the US and Europe; for Japan, it is April 2017.

 

IMPORTANT DISCLOSURES

This commentary is for use of Professional Clients only, except in the U.S. where the material may be redistributed or used with the general public.

The views and opinions are those of the author as of the date of publication and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all portfolio managers at Morgan Stanley Investment Management (MSIM) or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.

Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors. These conclusions are speculative in nature, may not come to pass and are not intended to predict the future performance of any specific Morgan Stanley Investment Management product.

Certain information herein is based on data obtained from third party sources believed to be reliable. However, we have not verified this information, and we make no representations whatsoever as to its accuracy or completeness.

This material is a general communication, which is not impartial and all information provided has been prepared solely for informational and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision.

There is no assurance that a strategy will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline. In general, equities securities’ values also fluctuate in response to activities specific to a company. Stocks of small- and medium-capitalization companies entail special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. Investments in foreign markets entail special risks such as currency, political, economic, market and liquidity risks. Illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Non-diversified portfolios often invest in a more limited number of issuers. As such, changes in the financial condition or market value of a single issuer may cause greater volatility.

Charts and graphs provided herein are for illustrative purposes only. Past performance is no guarantee of future results.

The indexes are unmanaged and do not include any expenses, fees or sales charges. It is not possible to invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or promoted by the applicable licensor and it shall not have any liability with respect thereto.

The S&P 500® Index measures the performance of the large cap segment of the U.S. equities market, covering approximately 75% of the U.S. equities market. The Index includes 500 leading companies in leading industries of the U.S. economy. The Nikkei 225 Index is a price-weighted index of Japan’s top 225 blue-chip companies on the Tokyo Stock Exchange. The EURO STOXX 50 Index is a market capitalization-weighted stock index of 50 large, bluechip European companies operating within Eurozone nations. The universe for selection is found within the 18 Dow Jones EURO STOXX Super sector indexes, from which members are ranked by size and placed on a selection list.

This communication is not a product of Morgan Stanley’s Research Department and should not be regarded as a research recommendation. The information contained herein has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

This commentary is only intended for, and will be only distributed to, persons resident in jurisdictions where distribution or availability would not be contrary to local laws or regulations.

There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.  Prior to investing, investors should carefully review the strategy’s / product’s relevant offering document. There are important differences in how the strategy is carried out in each of the investment vehicles.

EMEA:

This communication was issued and approved in the United Kingdom by Morgan Stanley Investment Management Limited, 25 Cabot Square, Canary Wharf, London E14 4QA, authorized and regulated by the Financial Conduct Authority, for distribution to Professional Clients only and must not be relied upon or acted upon by Retail Clients (each as defined in the UK Financial Conduct Authority’s rules).

Financial intermediaries are required to satisfy themselves that the information in this document is suitable for any person to whom they provide this document in view of that person’s circumstances and purpose. MSIM shall not be liable for, and accepts no liability for, the use or misuse of this document by any such financial intermediary. If such a person considers an investment she/he should always ensure that she/he has satisfied herself/himself that she/he has been properly advised by that financial intermediary about the suitability of an investment.

U.S.:

A separately managed account may not be suitable for all investors. Separate accounts managed according to the Strategy include a number of securities and will not necessarily track the performance of any index. Please consider the investment objectives, risks and fees of the Strategy carefully before investing. A minimum asset level is required. For important information about the investment manager, please refer to Form ADV Part 2.

Please consider the investment objectives, risks, charges and expenses of the funds carefully before investing. The prospectuses contain this and other information about the funds. To obtain a prospectus please download one at morganstanley.com/im or call 1-800-548-7786. Please read the prospectus carefully before investing.

NOT FDIC INSURED | OFFER NOT BANK GUARANTEED | MAY LOSE VALUE | NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY | NOT A BANK DEPOSIT

HONG KONG:

This document has been issued by Morgan Stanley Asia Limited for use in Hong Kong and shall only be made available to “professional investors” as defined under the Securities and Futures Ordinance of Hong Kong (Cap 571). The contents of this document have not been reviewed nor approved by any regulatory authority including the Securities and Futures Commission in Hong Kong. Accordingly, save where an exemption is available under the relevant law, this document shall not be issued, circulated, distributed, directed at, or made available to, the public in Hong Kong.

SINGAPORE:

This document should not be considered to be the subject of an invitation for subscription or purchase, whether directly or indirectly, to the public or any member of the public in Singapore other than (i) to an institutional investor under section 304 of the Securities and Futures Act, Chapter 289 of Singapore (“SFA”), (ii) to a “relevant person” (which includes an accredited investor) pursuant to section 305 of the SFA, and such distribution is in accordance with the conditions specified in section 305 of the SFA; or (iii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. In particular, for investment funds that are not authorized or recognized by the MAS, units in such funds are not allowed to be offered to the retail public; any written material issued to persons as aforementioned in connection with an offer is not a prospectus as defined in the SFA and, accordingly, statutory liability under the SFA in relation to the content of prospectuses does not apply, and investors should consider carefully whether the investment is suitable for them.

AUSTRALIA:

This publication is disseminated in Australia by Morgan Stanley Investment Management (Australia) Pty Limited ACN: 122040037, AFSL No. 314182, which accept responsibility for its contents. This publication, and any access to it, is intended only for “wholesale clients” within the meaning of the Australian Corporations Act.

All information contained herein is proprietary and is protected under copyright law.

Morgan Stanley Investment Management is the asset management division of Morgan Stanley.

This document may be translated into other languages. Where such a translation is made this English version remains definitive. If there are any discrepancies between the English version and any version of this document in another language, the English version shall prevail.

 

CRC 1813379 Exp 06/06/2018

It is important that users read the Terms of Use before proceeding as it explains certain legal and regulatory restrictions applicable to the dissemination of information pertaining to Morgan Stanley Investment Management's investment products.

The services described on this website may not be available in all jurisdictions or to all persons. For further details, please see our Terms of Use.

Not FDIC Insured—Offer No Bank Guarantee—May Lose Value
Not Insured By Any Federal Government Agency—Not A Deposit

Privacy & Cookies    •    Terms of Use

©  Morgan Stanley. All rights reserved.

Morgan Stanley Distribution, Inc. Member FINRA/SIPC.