Strategy: Global central bank policy divergence deepens

24 Oct 2016

  • Fed and ECB: waiting for December
  • Brazilian central bank starts easing cycle; Canada and Australia could join in soon
  • Market has already discounted stronger US company earnings
  • Asset allocation: unchanged even as yields dip

While many markets are focusing on the timing and pace of interest-rate rises in the US, the past week showed that many other central banks are still moving in the opposite direction to the Federal Reserve, causing global policy divergence to deepen. The ECB told us that we will have to wait until December; the Brazilian central bank started its widely expected easing cycle, while Canadian central bankers discussed further easing. In Australia, additional rate cuts firmly depend on the next inflation numbers. Better US corporate earnings reports did not lift US equities much, although a partial reversal of the uptrend in bond yields was positive for equities.


In the US industrial production expanded marginally, while capacity utilisation increased by a notch. Sentiment among homebuilders slipped, but is still as high as it tends to be during a phase of economic expansion. Housing market data overall continues to show a stable market. Headline inflation rose, mainly due to higher energy prices. We think these numbers do not change the chances of a rate rise in December. The data is good enough, inflation has shown signs of acceleration and the Fed remains keen to normalise interest rates (albeit gradually).


After the latest council meeting, the ECB left its existing quantitative easing programme at EUR 80 billion of monthly asset purchases, noting a resilient economy on a steady recovery trend with a gradual increase in inflation. But the risks are still tilted to the downside and the central bank remains committed to preserving the currently substantial degree of monetary accommodation. The ECB saw no signs yet of a convincing upward trend in underlying inflation. At the same time, credit conditions are no longer easing for companies. Moreover, banks expect to tighten conditions in the current quarter. In December, the ECB will have fresh data on the shape of the economy as well as the results of a review of the functioning of quantitative easing. We expect it to extend the asset purchases to September 2017 then.

While the October ECB meeting was essentially a non-event, as expected, markets were disappointed. The absence of further easing caused equity markets to fall briefly. The resulting strength in the euro has persisted.


Banco do Brasil cut the main Brazilian interest rates by 25bp to 14% now that inflation has changed course and progress is being made on fiscal reforms. Falling inflation has actually pushed up the real official interest rate since early this year. While the easing cycle is now underway, we expect further moves, but only at a gradual pace. At 8.5%, inflation is still well outside of the 2.5%-6.5% target range and recently the decline in some cyclical components has stalled. Secondly, the fiscal reform process may take time to complete.


The Canadian central bank lowered its growth forecast and governor Poloz surprised markets by saying that adding more stimulus to the economy was actively discussed, but uncertainty about the US elections, the outlook for the Canadian housing market and the commodity cycle kept the bank from acting immediately. It is not the first time that governor Poloz has surprised the markets: the BoC cut rates in January 2015. The latest meeting also marked the second time in six months that the bank admitted it had discussed more easing. Weak August retail sales have reinforced the likelihood of a rate cut in Canada in the near term.


Weak labour market data has increased the chance of monetary easing by the Reserve Bank of Australia. The dilemma for the RBA is the strong housing market, particularly in Sidney, and the negative terms-of-trade shock from commodities. This did not keep it from easing policy in August after lower-than-expected second-quarter inflation. Thus, inflation trends may be crucial.


In China, more monetary easing looks unlikely at this point. Official data showed that GDP growth was stable at 6.7% YoY in the third quarter. So the government is on course to reach its growth target of 6.5%-7% this year. Strong monetary and fiscal stimulus has led to some improvements in growth. That said, industrial production and real retail sales have slipped and while the Chinese renminbi has weakened, exports have continued to struggle. The durability of China’s stabilisation is still a big question mark, in our view.


About a quarter of US listed companies have so far reported earnings for the third quarter. Earnings per share have posted the strongest beat rate since the second quarter of 2010, while annual sales is showing growth for the first time since the final quarter of 2014. With the drag from the energy and basic materials sectors fading, earnings growth has also turned positive. So far, banks stand out positively due to a strong revival in fixed income and currency trading. Markets had anticipated the improving earnings outlook, leaving equities looking even more expensive. Our view on US equities is broadly neutral.


In the past week, 10-year bond yields in the US and Germany retreated slightly. In Japan they were more stable at 5bp below the Bank of Japan’s target of 0%, which we see acting as an anchor for Japanese 10-year yields. The slight dip in bond yields supported equities, running counter to the concerns over rising yields that had come to haunt equity markets lately. However, the moves were generally not significant enough to nudge markets out of their recent trading ranges. Thus, the tug of war between equity and bond markets looks set to continue.


WSU 241016