Expectations of long-term low interest rates are stretching sharemarket valuations, write Stewart Brentnall and Mark Rider.
Markets were shocked by last month’s vote in favour of Brexit. In late June, sharemarkets fell, the Britain’s pound plummeted and safe-haven assets such as the Japanese yen, highly-rated government bonds and gold all rose in value.
By mid-July, sharemarkets had largely brushed off any negative Brexit effect.
Britain’s stock exchange more than reversed its initial fall, no doubt benefitting from a weaker pound. And the US sharemarket climbed to an all-time high creating a surprising scenario where falling bond yields (which normally suggest poor economic times ahead) coincided with firmer sharemarkets. Very much a case of bad news, as it turns out, being good news for the sharemarket.
For Britain, there’s little doubt the short-term impact of Brexit is negative. It has created heightened uncertainty about the nation’s trading relationships with the eurozone and the rest of the world, and there’s a likelihood that investment and consumption will weaken.
Looking further ahead, it’s possible that with constructive political and economic leadership Britain may be better off outside of a bureaucratic and fracturing Europe. Only time will tell.
In Europe, while there’s less of a direct short-term impact, Brexit could motivate EU member states to leave the union. While this threat isn’t immediate, the more moderate rebound in eurozone stocks suggests concerns for potential trouble.
Brexit reinforces existing trends
Rather than introducing a new dynamic to financial markets, we believe Brexit is reinforcing two existing trends that have been playing out in the first half of 2016.
1) Moderate global growth
The direct impact of Brexit is to weaken global economic growth, reinforcing the current modest pace. This is based on widespread expectation the UK economy will experience a significant downturn, and possibly a recession, in the coming year.
2) Even easier monetary policy
This year started with speculation of when, not if, the US Federal Reserve would raise rates. Six months on the market is not convinced the Fed is going to hike in the next couple of years.
To some extent the Fed is now acting more like a global, rather than US, central bank – increasingly worrying about the impact of its decisions beyond its shores. Brexit has given it another excuse to leave rates on hold.
With expectations of a possible loss of momentum in Europe and a stronger Japanese yen, the market is also expecting more easing from the European and Japanese central banks.
Low rates as far as the eye can see
If we look at expectations for where the US Fed funds rate will be in 10 years (see chart), the market is pricing only 1 per cent compared with the current 0.4 per cent, which doesn’t suggest much of a hiking cycle at all.
Market pricing has the Reserve Bank of Australia’s cash rate at its current 1.75 per cent in 10 years. In Europe and Japan policy rates are expected to remain around 0 per cent or lower.
Source: Bloomberg, ANZ Wealth
With these assumptions, it’s no wonder 10-year bond yields are so low. However, for these assumptions to be right, weak growth and no inflation must be a permanent feature of the economic environment.
This is somewhat contrary to the developments we see in the US and Europe, where growth is strong enough to bring down the unemployment rate, and underlying inflation is picking up in the US and stablising in the eurozone.
With very few rate hikes priced in for the rest of the decade, this poses clear risks for sharemarkets as valuations become increasingly stretched.