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Hermes’ Neil Williams: The two headwinds that aren’t priced into markets

The chief economist tells FE Trustnet why investors should brace themselves for unfavourable inflation and ‘looser for longer’ monetary policy.

Lauren Mason

By Lauren Mason, Senior reporter, FE Tru...
Tuesday February 14, 2017

Quantitative easing (QE) is set to continue and unfavourable inflation could slow global growth as we head through 2017, according to Hermes’ Neil Williams (pictured), yet jubilant markets have not priced in either of these major macroeconomic headwinds.

The chief economist says the inauguration of Donald Trump as president has been well-received by investors given his plans for fiscal expansion, but warns that his protectionist policies could keep paradoxically loose monetary policy ticking over and introduce the “wrong kind of inflation” into the economy.

“There were two themes emerging last year, especially over the Brexit vote. One was that it was time for the big economies to do more than just keep interest rates low and that was to open the fiscal box and have more belt loosening on the fiscal side,” he said.

“The other one, which we thought would be prominent this year, was an increasing move away from globalisation more towards a ‘beggar thy neighbour’ approach. Then Mr Trump landed, and I would argue he has bought those two themes very much to the fore for this year.

“This leads me to two conclusions, both of which I don’t believe markets are fully appreciating. The first one is that stock markets and other growth assets are perhaps riding too high on the reflation trade, which seems to be the best of Trump’s pro-growth policies and includes the tax cuts we’re going to get in June.”

Performance of indices since US election 2016


Source: FE Analytics

While Williams believes fiscal expansion – which he also expects from the UK and the eurozone this year – is the correct move to make over the short term, he warns that markets are turning a blind eye to Trump’s protectionist policies.

He believes trade barriers could lead to a shortage of goods and service in the US which, in turn, could cause unfavourable inflation, compromising consumer spending power and eventually weighing on global growth.

“Trump is looking at roughly a $4trn hit to tax revenue over the first term, which is over one-fifth of the economy. That’s a big hit,” the chief economist said.

“Inflation probably will pick up and it’s difficult to see how those tax cuts won’t lead to greater spending. But again, it’s the wrong sort of inflation for me.

“You could argue that Congress could stop Trump pushing through these fiscal measures, which they could. What worries me is that it can’t stop Trump when it comes to trade.

“While we’re worried over here about Article 50, the US is worried about Article 301 of the 1974 Trade Act. It means the serving president can impose trade restrictions, including tariffs, on any country he or she deems to be acting against the interests of the US and Congress does not have the authority to stop it.”

Williams’ major concern is how trade tariffs will impact the broader economy as opposed to the US directly, given that it is relatively closed in terms of exports.

For instance, he warns that China could react to any trade tariffs implemented by the US through devaluing the renminbi further, which is likely to have a knock-on effect on market behaviour.

“This could develop into a bar room brawl where there is a gradual creep into a move away from globalisation. You get that inflation because there’s a shortage of goods and services and labour, but it’s the wrong sort because it slows down growth,” he continued.

“If I’m right about this dark cloud of protectionism looming over us, that will probably be the right thing to do.”

The second potential headwind, according to Williams, is that central banks will keep interest rates low despite an increase in inflation, which could mean the hunt for yield becomes even more intense than it has been over the last two years.

As such, he says the concept of a great asset class rotation from fixed income into equities is potentially misplaced.

Performance of indices since start of FE data


Source: FE Analytics

“One reason I believe central banks won’t turn the taps off on QE is simply because they themselves now have skin in the game. Because the ‘big four’ central banks have now pushed out $13trn of liquidity, not even including QE from Switzerland and Sweden,” he explained.

“Their balance sheets are predominantly government bonds and so, if for some reason they start to embark on an increase of interest rates and government bond yields rise because they initiate this too early, they will themselves feel part of this pain.

“Everything is going to have to be very measured and carefully explained ahead of time. It is more of the same when we hear from central banks, it is going to be a very gentle, step-by-step process. I’m not sure central banks can ever fully turn off QE.”

The chief economist uses the Japanese central bank as a prime example of this, given it is now accelerating QE after implementing it for 18 years.

He also says the US Federal Reserve’s reaction to the depression of the 1930s suggests that loose monetary policy won’t disappear any time soon, despite widespread belief that QE will taper and make way for fiscal loosening.

“The last time the Fed adopted QE properly was to drag the economy out of the 1929 depression. It ran QE for 14 years unbroken between 1937 and 1951, even though inflation was in double digits throughout and touched 20 per cent in 1947,” Williams said.

“I know this is a very different time but, given this is probably the best guide we have in terms of policy, you could say that after eight years we’re only halfway through cheap money.”

The chief economist believes there is “more cream to come” in terms of stock market upside over the near term, given the size of Trump’s tax cuts will be announced in June and should be received favourably.

Over a slightly longer time scale, he says markets are likely to correct at some point this year. However, he says a liquidity cushion from central banks would prevent a 2008-style crash.

“The notion of a grand rotation out of government bonds and into stock markets forever to me looks misplaced,” he continued.

“If Japan – which again is our best case study for QE - is leading the way in terms of their 10-year government bond yields, 10-year treasuries, bunds and gilts could see their yields fall further.

“Seven or eight years ago it was maybe considered to be a coincidence that we were heading down the ‘Japanification’ route. Whereas now, for this great rotation to take place, markets really have to be convinced that ‘Japanification’ is over.

“For that to happen, it seems to me surely that central banks are going to have to flag up that they’re no longer going to keep the taps running. I doubt at this stage that they are able to do that and we’re certainly not seeing any hint from them that that’s the case.”

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