At the beginning of this new year, the big question on the lips of everyone involved in European capital markets is how the unwinding of central bank stimulus will play out.
Markets have been spoilt by nine years of continuous quantitative easing by one or more of the world’s leading central banks. The $13tr of printed money has almost guaranteed performance for bond investors, kept a lid on yields and neutralised volatility.
Arguably it has done the same for equities. The biggest ever rally in the S&P 500, which has taken it to 70% above its 2007 peak, has followed a path almost exactly parallel to that of the three big central banks’ swelling balance sheets, as Yardeni Research points out.
But 2018 will be the year when it all changes. In January, the European Central Bank’s monthly bond purchases fall from €60bn to €30bn, and its president Mario Draghi has only guaranteed the programme’s continuation until September. After that, the ECB will continue to reinvest the proceeds from maturing debt, but may not grow its balance sheet any more.
Draghi and the other rate-setters could easily change course if the euro zone’s economy goes soggy, but at the moment the forecast for 2018 is 2.1% growth.
The US Federal Reserve, having stopped asset purchases in October 2014, has recently begun to let the $4.5tr of assets it has accumulated since November 2008 start, very gently, to decline.
Jerome Powell, who takes over as Fed chair in early February, is widely expected to continue to raise rates. The Fed has pointed to three rate hikes this year and Goldman Sachs expects nine by the end of 2019, given the strength of the US economy and jobs market.
Despite these big changes coming down the pipe, investors appear incredibly relaxed. 2017 was a sensational year for equity and bond markets. At the time of writing, the S&P 500 had climbed by 18% in 2017, the Euro Stoxx 50 by 9%.
More than $11tr of sovereign and corporate bonds were trading at yields below zero at the end of November. US bond funds sucked in nearly $200bn of inflows last year, up to December 9, according to EPFR, and for the third year running, companies (and banks) raised more than $700bn of debt in the US longer than 10 years.
In Europe, investment grade and high yield bond issuance hit records, and markets remained exceptionally busy and hot, even after Draghi announced the halving of bond purchases.
Why so numb ?
Why are markets so numb to the painful alterations 2018 could bring? Some would call this a happy ending. Central banks have nursed economies back to health, and are now retiring; markets should be able to function properly and efficiently without further assistance.
Others believe markets have become dangerously complacent, and are underestimating the crucial role central banks have played in creating these incredible market conditions, by keeping the cost of credit extremely low and acting as a salve during periods of political or economic anxiety.
“While the bond market has significant amounts of capital redeeming each year, the current buoyancy of both equity and credit markets, together with a likely change in direction for global rates and quantitative easing, suggests that borrowers in 2018 should be prepared for an investor base that doesn’t necessarily perceive the market as a one way bet any more,” says Anthony Barklam, co-head of debt capital markets — bonds and loans — at MUFG in London.
All agree that healthy markets need that return to a fuller consciousness of risk. But almost all actors in the economy have got used to paying next to nothing for their debt. It would not take many percentage points more on interest rates to double or triple their borrowing costs. And history suggests that a rise in rates, especially a sustained one, is very often the trigger for a recession.
As central banks beat their retreat, normalisation is a word capital markets could well come to despise in 2018.