The overall recovery in the US is on track, with the unemployment rate coming in at 4.3% in May, the lowest since May 2001. In response to the stabilizing economy, the Fed concluded that the economy no longer needs help and therefore scheduled three increases in interest rates for 2017. In addition, the Fed is actively considering a profound change in US monetary policy – shrinking its portfolio of Treasuries and mortgage-backed securities. Many investors are concerned that the shrinkage of the balance sheet may impair global liquidity. Well, I don’t think so.
The Fed’s balance sheet in total now runs US$4.5 trillion, of which US$3.7 trillion came from buying Treasuries and mortgage-backed securities in response to the financial crisis in 2008. This quantitative easing aimed at injecting money into the economy and encouraging bank lending to revitalize the then anemic economic growth. The Fed stopped buying large quantities of assets in October 2014. Since then, it has kept the size of its balance sheet constant, buying just enough to replace maturing securities.
As long as the Fed just allows its portfolio of bonds to run off gradually as they mature, the shrinkage is unlikely to have any significant impact on global markets. This is because global liquidity is still well supported by other G5 central banks – a total of more than US$18 trillion, of which the US represents only about 23% (Note 1). The US balance sheet shrinkage itself will not undermine the global liquidity, as other central banks are unlikely to retreat their aggressive accommodative policies together.
Note 1: Macquarie Research, Bloomberg, as at 22 May 2017
Despite the fact the Fed is proposing to shrink its balance sheet, overall interest rates remain low, and investors struggle find any returns from government bonds. Equities remain the choice for pension investors seeking growth. We continue to favor US equities due to their large exposure to the world’s leading technology companies – companies that are shaping the world. These companies, representing about 20% of the US equity market, will not only benefit from the US domestic recovery but also global demand for their innovative products and services. Their earnings growth, much more sustainable than Europe, remains the key driver for the equity market, together with benign inflation and economic expansion.
Europe has been doing well this year, up 15.8% (MSCI Europe-EUR) over the past 12 months, driven mainly by cyclicals such as financials, industrials, energy and materials. Unlike the US, Europe is dominated by “cyclical stocks,” which are closely geared to economic conditions, and commodity prices. The strong earnings growth of European cyclicals is largely the result of stronger commodity prices in 2016, which may not be sustainable heading into the second half of the year as commodities have retreated recently. The outlook for Europe remains unclear given the series of political elections, which may lead to market swings that pension investors don’t want to see. The French election gives some indication on the German election scheduled for later in the year, but it will still need to be closely monitored. Structural headwinds surrounding Brexit, as well as high levels of excess leverage and negative geopolitical developments, are also likely to constrain growth in the region.