JPM: "Central Banks Have Created Unprecedented Distortions In Government Bond Markets"

Posted on by Timothy Hare

As part of his just released 2017 outlook, JPM’s Michael Cembalest, chairman of markets and investment strategy, notes that while “political upheavals and unorthodox central bank actions persist” he prdictes “more of the same in 2017: single digit returns on diversified investment portfolios as the global economic expansion bumps along for another year.” Of course, the alternative is a recession call, which considering the current expansion will be the third longest in US history by the time Trump is inaugurated in less than three weeks, is probably not too farfetched.

Something else, however, caught our eye: the same observation that was considering “fake financial news” less than a decade ago, and is now part of the mainstream jargon – the following statement by the JPM strategist:

“True Believer” central banks have created unprecedented distortions in government bond markets. Bond purchases and negative policy rates by the ECB and Bank of Japan led to negative government bond yields. Whatever their benefits may be, they also resulted in profit weakness and stock price underperformance of European and Japanese banks. The poor performance of European and Japanese financials was a driver of lower relative equity returns in both regions in 2015/2016.

We agree, and now that these “True believes” are being phased out – at least in mental models, and if only for the time being – replaced by hopes that Trump’s still undetermined fiscal policies and a global push for reflation will somehow bootstrap the global economy groaning under trillions in excess debt, and swamped by a demographic picture that is massively deflationary, we are far less sanguine about the “single-digit gains” forecast by JPM.

In any case, here is the Executive Summary from JPMs “Eye on the Market” outlook for 2017, a preamble to a far longer piece noted below.

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Political upheavals and unorthodox central bank actions persist, but it looks like more of the same in 2017: single digit returns on diversified investment portfolios as the global economic expansion bumps along for another year.

How we got here. By the end of 2014, central bank stimulus lost its levitating impact on markets, GDP and corporate profits, all of which have been growing below trend. Proxies for diversified investment portfolios generated returns of just 1%-3% in 2015 and 6%-7% in 2016

The biggest experiment in central bank history ($11 trillion and counting as of November 2016) helped employment recover in the US and UK, and more recently in Europe and Japan. Across all regions, however, too many of the benefits from this experiment accrued to holders of financial assets rather than to the average citizen. As a result, the political center of a slow-growth world has begun to erode, culminating with the election of a non-establishment US President with no prior political experience, and the UK electorate’s decision to leave the European Union. The market response to Trump’s election has been positive as investors factor in the benefits of tax cuts, deregulation and fiscal stimulus and ignore for now potential consequences for the dollar, deficits, interest rates, trade and inflation (see US section on the “American Enterprise Institute Presidency”).

True Believer” central banks have created unprecedented distortions in government bond markets. Bond purchases and negative policy rates by the ECB and Bank of Japan led to negative government bond yields. Whatever their benefits may be, they also resulted in profit weakness and stock price underperformance of European and Japanese banks. The poor performance of European and Japanese financials was a driver of lower relative equity returns in both regions in 2015/2016.

For the last few years, I have written about a preference for an equity portfolio that’s overweight the US and Emerging Markets, and underweight Europe and Japan. This has been one of the most consistently beneficial investment strategies I’ve seen since joining J.P. Morgan in 1987 (see chart below, right). It worked again in 2016, and despite the negative consequences of rising interest rates and a rising dollar for US and EM assets, I think it makes sense to maintain this regional barbell for another year as Europe and Japan once again snatch defeat from the jaws of victory.

We had a single digit portfolio return view for 2015 and 2016 (which is how things turned out), and we’re extending that view to 2017 as well. There are some positive leading indicators which I will get to in a minute, but first, the headwinds:

  • While global consumer spending has held up, global business fixed investment remains weak, in part a consequence of the end of the commodity super-cycle and slower Chinese growth
  • We expect the emerging market recovery to be gradual, particularly if Trump policies lead to substantially higher interest rates and a higher US dollar
  • We expect a near-term US growth boost (amount to be determined based on the composition of tax cuts, infrastructure spending and deregulation), but trend growth still looks to be just 1.0% in Japan and 2.0% in Europe
  • The global productivity conundrum continues, leaving many unanswered questions in its wake
  • Even though private sector debt service levels are low, high absolute amounts of debt may constrain the strength of any business or consumer-led recovery

  • And finally, even before Trump takes office, we’re already seeing a rise in protectionism as global trade stagnates. The degree to which Trump follows through on campaign proposals on trade is a major question mark for 2017

So, with all of that, why do we see 2017 as another year of modest portfolio gains despite the length of the current global expansion, one of the longest in history? As 2016 came to a close, global business surveys improved to levels consistent with 3% global GDP growth, suggesting that corporate profits will start growing at around 10% again after a weak 2016. More positive news: a rise in industrial metals prices, which is helpful in spotting turns in the business cycle (see Special Topic #8).

Furthermore (and I understand that there’s plenty of disagreement on the benefits of this), many developed countries are transitioning from “monetary stimulus only” to expansionary fiscal policy as well. Political establishments are aware of mortal threats to their existence, and are looking to fiscal stimulus (or at least, less austerity) as a means of getting people back to work. The problem: given low productivity growth and low growth in labor supply, many countries are closer to full capacity than you might think. If so, too much fiscal stimulus could result in wage inflation and higher interest rates faster than you might think as well. That is certainly one of the bigger risks for the US.

So, to sum up, here’s what we think 2017 looks like:

  • A modest growth bounce in the US from some personal and corporate tax cuts, deregulation and infrastructure spending, with tighter labor markets, rising interest rates and a stronger dollar eventually taking some wind out of the US economy’s sails. If I’m underestimating something, it might be the potential increase in confidence, spending and business activity resulting from a slowdown in the pace of government regulation
  • A little better in Europe and Japan in 2017, but no major breakout from recent growth trends
  • China grows close to stated goals, supported by multiple government bazookas firing at once
  • Emerging markets ex-China continue recovering after balance of payments adjustments; while countries with high exposure to dollar financing will struggle, overall risks around a rising dollar have fallen markedly since 2011
  • The world grows a little faster in 2017 than in 2016, but as shown above, a lot of that is already in the price of developed market equities. So, another single digit portfolio year ahead

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Much more in the full forecast below (link)


Source: zero hedge

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