Quantitative Tightening

Financial markets are indeed living in unprecedented times. It is very difficult to assess the potential issues that could arise when there are little or no historical events that are like the actions taken by Central banks to keep the economy humming along after the “Great Recession” of 2008/2009. Quantitative easing (QE), as we know it, has helped keep long term interest rates down, so that businesses and the economy can maximise their chance of recovery. It certainly wasn’t ideal, but it did the job (slowly). Eventually, consumer confidence lifted, and businesses rebuilt their financials and markets recovered, many to new highs.

By pushing rates to zero or near zero, Central Banks effectively “forced” investors to take on more risks and bid up assets such as real estate and shares, creating a wealth effect to enable consumers to spend again. While this eventually occurred, the pattern has been unlike any recovery in history and the rate of growth has been far slower, with no inflationary pressures in sight thus far.

Over the past year, the US Federal Reserve (the Fed) has begun to unwind QE. They are raising short term rates to enable interest rates to revert back to more normal levels of around 3.5% to 4%. The Fed is also worried that inflationary pressures may start to come through and do not want to be left chasing this by being too slow in raising rates. The tightening process can be a key threat if the US Federal Reserve end up tightening too far without the eventual inflationary pressure, in effect killing off the economic recovery.

A Strong (US) Economy - Adding Fuel to Fire

President Trump’s fiscal stimulus over the past year (tax cuts and infrastructure spending) have added more fuel to the US economy at a time when US unemployment rates are at historically low levels. Interest rates are one of the most important inputs in market valuations. While the economic data is not showing a jump in inflationary pressures just yet, the consensus view has been that the stimulus and full employment has put a lot of upward wage pressures within companies, adding to inflationary concerns soon. The US Federal Reserve wants to make sure that they are not caught off guard and prefers to reign over inflationary pressures before it really shows up. However, comments by the US Federal Reserve Chairman at the end of November contradicted market expectations, indicating that rates may now be closer to neutral compared to comments he made just over a month ago. Whether this is a short-term change of heart or an indication of the end of interest rate hikes will be one of the key points to look out for in financial markets throughout 2019.

Valuation

The low interest rate environment over the past few years has led to stretched asset pricing across almost all asset classes globally. While we are only seeing small pockets of extreme valuations in small sections of the economy, such as new technology and selected consumer discretionary companies, the overall market is showing levels at or above fair value. The recent pullback in markets has re-set valuation back to fair levels.

With an array of headwinds above, we head into 2019 with a fairly cautious mindset. However, any positive outcome relating to the China-US trade deal, US interest rates and/or better than expected earnings growth could easily fuel the momentum back in favour of growth assets such as equities. Certainly, we are seeing the first sign of a return to upward momentum, as at time of writing.

Whether we experience a short-term rally or a longer term sustained rise in equities will be determined by the factors raised above. Until recently, the two years until October 2018 have been unusually calm for financial markets. We sense that 2019 will be more volatile with more pullbacks and rebounds than what we have experienced over the past two years. Looking at it from a positive view, volatility often leads to opportunities and 2019 could prove that sort of year.

Please feel free to discuss the above or any financial matters you may have with your advisers.

Disclaimer: This publication has been compiled by Financial Decisions (AFSL/ACL Number 341678). Past performance is not a reliable indicator of future performance. While every effort has been taken to ensure that the assumptions on which the outlooks given in this publication are based on reasonable data, the outlooks may be based on incorrect assumptions or may not take into account known or unknown risk and uncertainties. Material contained in this publication is an overview or summary only and it should not be considered a comprehensive statement on any matter nor relied upon as such. The information and any advice in this publication do not take into account your personal objectives, financial situation or needs. Therefore you should consider its appropriateness having regard to these factors before acting on it. While the information contained in this publication is based on information obtained from sources believed to be reliable, it has not been independently verified. To the maximum extent permitted by law: (a) no guarantee, representation or warranty is given that any information or advice in this publication is complete, accurate, up-to-date or fit for any purpose; and (b) Financial Decisions nor its employees are in any way liable to you (including for negligence) in respect of any reliance upon such information or advice. December 2018

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