To quote Winston Churchill: “Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.” 
Economic and monetary policy divergence has been a feature of the global economy for some time, but was less of a focus for investors in the first half of this year, thanks to softer growth in the US and better data in Europe and Japan.
Macroeconomic momentum, however, looks to be shifting again, with divergence likely to re-emerge as a major theme for financial markets over the next 12 months.
So far asset prices and currencies have largely moved to reflect divergence in the extent of policy easing.
Now markets need to begin to adjust to monetary policy moving in different directions around the globe signalling a fairly fundamental shift in policy settings and a move towards policy normalization which is about to start – with potentially major implications for the absolute and relative pricing of markets over the medium-term.
In our view, a new era is starting and markets will need to reflect this. Below, we outline three themes informing our views:
The US economy is further ahead in the cycle than the rest of the world
It has been apparent for a while that the US economy is further ahead in the business cycle than the rest of the world. The economic improvement has now reached a point where Janet Yellen, governor of the Fed, believes that it will probably be “appropriate at some point this year to raise the federal funds rate”.
The first rate increase may come as soon as the end of the summer, with a gradual path of tightening seen as likely thereafter. It still seems likely that the Fed will move first, as has typically been the case, but the Bank of England may be close behind.
Market adjustments in response to monetary policy moving in different directions around the globe should give the US dollar bull market fresh legs, albeit less so against sterling than other currencies.
Performance of sterling, euro and yen against US dollar over 2yrs
Source: FE Analytics
Bond market pricing should also diverge, not least because the US treasury market isn’t yet priced for near-term interest rate increases with the first hike only fully priced for next January and little thereafter.
The UK is approaching a similar point in the cycle, with unemployment down substantially and average hourly earnings on the rise. BoE governor Mark Carney has indicated that the first interest rate increase is likely ‘at the turn of this year’, and the previously dovish member of the Monetary Policy Committee, David Miles, now believes that the time to raise rates is “soon”.
Ultimately, US interest rates appear to have more upside, with the UK economy being more sensitive to changes in short-term interest rates and to currency appreciation.
By contrast, the rest of the world is still easing
But the rest of the world is still easing policy and is likely to continue to do so.
The European Central Bank looks set to follow through with QE until at least next September. The Bank of Japan is similarly committed to expanding its balance sheet well into 2016. The People’s Bank of China has stepped up policy support for the weakening economy and stock market, with rate cuts, reductions in reserve requirements and other targeted measures.
In the last three months, 15 central banks have announced additional easing measures, with some moving more than once. A number of these have loosened policy to match or exceed the easing in their largest neighbours in order to try to maintain competitiveness.
These include the banks of Sweden, Norway, Hungary and Korea, who are attempting to keep pace with policy in the eurozone and Japan. Others, such as Canada, Australia, New Zealand and Russia are struggling to deal with the impact of the collapse in Chinese demand and commodity prices on their growth rates.
Any setback should be a buying opportunity rather than the beginning of a new bear market
A shift towards tightening by the US may also prove unsettling for riskier assets which have become used to zero interest rates in recent years.
Performance of indices over 6yrs
Source: FE Analytics
A probable pick-up in volatility, however, is unlikely to permanently derail equity markets, given tightening will reflect an improvement in growth and is still likely to leave interest rates at fairly accommodative levels initially.
As a result, any setback should be a buying opportunity rather than the beginning of a new bear market.
John Stopford is portfolio manager of the Investec Diversified Income fund. The views expressed above are his own and should not be taken as investment advice.
