By David Curmi
Over recent months there has been a sea change in the monetary stance taken by Central Banks. It all started back in January where Federal Reserve Chairman Jerome Powell signaled a shift in stance. After raising interest rates consistently since December 2015, and after projecting 2 further increases in December 2018, the combination of weak markets and some conflicting signals in the US economy forced the Fed to change to a wait and see approach. This culminated in a first cut of 25bp in US rates on Wednesday thereby heralding the possibility of a new easing cycle as risks to global economies grow, even at a time when the US economy remains relatively robust, especially if one were to look at US unemployment, which is at historically low levels. It is the continued weak inflation that has spooked the Fed, and as indicated in the statement accompanying the cut, the Fed will continue to assess incoming data and economic conditions in shaping the future path of its policy rate. Central Banks in Australia, New Zealand and India, amongst others have followed suit.
More recently our very own ECB has signaled a shift in policy. Quite frankly it hardly felt that we were on the path to raising interest rates, yet last week Draghi hinted that QE may be back on the cards, and a further cut, deeper into negative territory is being assessed. The reason, indications of economic pain on the horizon. Recent economic data has indicated that the uncertainty coming from trade wars, Brexit and geopolitical events has tilted the balance of probabilities to the downside, forcing Central Banks to take preemptive action. The problem with this approach seems to me that it is now akin to the ECB pushing on a piece of string. Whilst the effect of this monetary easing is to make money cheaper to borrow, if businesses do not want to borrow because they are uncertain about the future, they simply will not do so, thereby stifling the impact such easing has.
For investors this presents a new challenge. Until recently we all hoped a return to normality implied an increase in interest rates. This is not about to happen any time soon and the Japanification of the Western world is a reality we are going to have to learn to live with. This means low or even zero rates of interest rates. It also means that a fueling of asset bubbles as we have seen in recent years is perhaps not about to stop. Cheap money will force investors into taking risks in search of yield. This may come in the form buying riskier fixed income securities or even buying equities that have attractive dividend yields. Either of these strategies needs careful consideration, especially for the uninitiated in such areas. It can be a dangerous space since one of the side effects of negative interest rates is that it fuels debt financed bubbles. It can also be rewarding if done wisely and within the risk parameters that each investor is able to withstand.
One area that could be attractive is the local bond market, both government and corporate. In the government sector, long dated bonds have come back into fashion and prices have risen already but there may be further to go. Corporate bonds on the other hand offer more attractive interest rates, but also contain higher risks. It is critical that you carefully select the bonds you buy. Not based on the coupon. This is a misnomer and will likely lead you into a dark alley, but on the strength and robustness of the business and its credit quality. This should not be difficult to do especially as the gap between the good and the bad is hardly more than 0.5%. Is it worth taking a big risk for that extra pick up in yield? Not at this stage in the cycle. Stay safe and live to see through this turmoil.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.