Strategy: What next for monetary policy?

24 Aug 2016


  • Corporate earnings beat low expectations; outlook less positive
  • Monetary policy: short-term and long-term outlook in play
  • Asset allocation: overweight US small caps vs. large caps

Sentiment on financial markets has remained positive during the summer. The S&P500 is close to all-time highs and emerging market equities have rallied well since their January low. With low government bond yields keeping investors searching for yield elsewhere, the risk spreads on corporate bonds and emerging market debt have tightened further. We have largely kept our defensive asset allocation but have implemented an overweight in US small cap equities versus US large caps, partly as a hedge for our defensive stance.


In the US, an above-average percentage of companies have surprised positively with their reported Q2 earnings. The sales surprise ratio also rose for the third straight quarter. That said, actual sales and earnings per share (EPS) growth were still negative; companies were able to surprise relatively easily as expectations had been low. Energy and basic materials were again the worst-performing sectors in terms of negative annual sales growth and EPS rates, although average earnings and/or sales in utilities, financials and technology also fell year-on-year. Overall EPS were down year-on-year, but by less than in the previous two quarters. In Europe, annual growth rates for sales and EPS were still firmly negative.

Nonetheless, the equity rally has pushed up equity valuations and we now think global equities have become expensive, although not excessively so. Our dividend discount models show that the US and the UK are expensive, while Japan and Germany are more fairly valued.

We are also cautious about the outlook for earnings. We think forward earnings expectations are too high and that further negative revisions can be expected. In the US, the corporate sector is suffering from an inventory overhang, although there are signs that this may soon end. However, margins may have peaked. In Europe, earnings may stay under pressure in the banking sector, while in Japan, the strong currency is detrimental to corporate earnings.


There are two main discussions evolving about monetary policy: Will there be any near-term changes, and what are the longer-term policy options?

As to the near term, the focus has been on the probability of a Fed rate increase this year and whether that should happen in September or December. Several Fed officials have recently hinted at an imminent rate hike. The minutes of the July FOMC meeting showed that the members remain divided. However, if growth holds up and the labour market stays on a firm footing, as we think it will, a rate hike later this year is well possible.

Discussion about the near-term path of the ECB’s monetary policy has quietened somewhat. The ECB seems satisfied with recent economic developments and its policy tool deployment. Yet with inflation still quite low, some further easing may be warranted. Most likely in our view would be an extension of the ECB’s asset purchase programme beyond March 2017.

In Japan, inflation is still well below the Bank of Japan’s 2% target. The target date for reaching that goal has been pushed backward several times. The situation persists stubbornly, despite massive quantitative easing and negative interest rates. The BoJ has said that it will release a comprehensive assessment of its monetary policy at its September meeting, although the implications of this are unclear. The BoJ could again delay reaching its inflation target, change the target, and/or accelerate its asset purchases. In a recent interview, BoJ governor Kuroda would not rule out further rate cuts.

Now to the longer-term prospects for monetary policy. With inflation and inflation expectations low, what else can central banks do? Instead of targeting inflation, they could target price levels or nominal GDP, enabling a temporary overshoot of inflation. They could drop “helicopter money” or directly increase companies’ or households’ cash balances to spur spending. These longer-term discussions suggest that we will be in a low-rate environment for some time yet, hence the search for yield and the positive sentiment in equity markets. With central banks reaching the limits of their options, attention has also shifted towards fiscal stimulus, as already seen in Japan and China, but perhaps also to be employed in the UK. In the US, both presidential nominees favour an infrastructure spending package.


We have kept our cautious asset allocation. We are underweight developed equities versus cash. We think equities are slightly overvalued and that the economic outlook is somewhat cloudy. Monetary policy is obviously positive. With most developed government bonds having negative yields, investors are pushed into higher yielding and more risky assets, including corporate bonds, emerging market debt and even equities. However, we see the earnings outlook as negative and we also foresee further downward revisions to analyst’s earnings estimates.

We are also underweight hard currency emerging market debt versus US government bonds. Risk spreads have continued to narrow, but we do not see this as justified by improving fundamentals. We think emerging market debt and equities are discounting a swifter-than-likely recovery. Related to this we are also underweight commodities.

In government bonds we prefer the US over broad eurozone government bonds. Yields are higher in the US and the steeper curve provides additional returns. We still see growth and political risks in some peripheral eurozone member states. We also prefer eurozone inflation-linked bonds over nominal government bonds. Inflation expectations embedded in this asset class are extremely low. Although we do not think higher inflation in the eurozone is imminent, we think the inflation-linked market has overshot somewhat. Higher headline inflation due to base effects from energy prices could be a trigger for higher inflation expectations.

New in our asset allocation is an overweight in US small cap equities versus large caps. US small caps have gradually started recovering from their underperformance this year, and small caps valuations have improved, especially on a relative basis versus large caps. We also think the earnings outlook for small caps has improved. Finally, mergers and acquisitions are positive for small caps. Additionally, we see this position, which would benefit further in a risk-on environment, as a hedge for our generally cautious asset allocation.

WSU 22Aug16