US and European equity markets have rebounded strongly in 2019.
Relative to the December 2018 lows, the S&P 500 has risen by almost 20%, while the Euro Stoxx 50 has gained more than 10%.
This is somewhat surprising as economic news has mostly deteriorated further and political uncertainties remain elevated.
By and large, it was the softer economic climate and political worries that had underpinned the market correction in the second half of 2018 in the first place.
Four factors have lifted stock markets since the beginning of the year.
First, markets may have discounted too much risk late last year. The sell-off in global equity markets of almost 20% on the back of stalling eurozone economies and signs of a US slowdown reduced valuations to attractive levels.
Second, policymakers in China have signalled additional fiscal and monetary stimulus to treat the ongoing economic slump in the world’s second-largest economy.
Third, some progress in US-China trade talks has raised markets’ hopes of a breakthrough between the world’s two largest economies that can avert a full-blown trade war.
Fourth, and most importantly for the story of markets so far in 2019, central banks have sent strong signals that they stand ready to alter their policy paths to bolster confidence and demand. In market speak, this is known as the central bank ‘put’.
A ‘put’ is a financial contract that is designed to protect against losses. The concept first gained notoriety during the tenure of Alan Greenspan as chairman of the Federal Reserve from 1987 to 2006.
Progress in US-China trade talks has raised markets’ hopes of a breakthrough
By promising to slow the pace of rate hikes, pause a tightening cycle, or indeed even by cutting interest rates in response to a correction in financial markets, a central bank can raise the expected level of future market liquidity and encourage risk-taking.
Central banks thus have the power to halt a decline in the prices of risky assets like equities, or in the case of the 2019 rally, partly reverse a previous correction.
In 2019, central banks have woken up to the risks and changed their tune accordingly.
In January, the US Federal Reserve did a U-turn following its December rate hike. The increase in the fed funds rate was coupled with guidance that the central bank’s balance-sheet reduction would be on ‘autopilot’.
This added to the climate of risk in financial markets that had long worried about the negative consequences on liquidity resulting from the Federal Reserve’s balance-sheet-reduction policy.
However, in January, the Federal Reserve retuned its forward guidance away from ‘further gradual increases’ in the fed funds rate to a more neutral statement of ‘patience’ to signal a pause in its rate hike cycle that started in December 2015.
It also signalled that the pace and duration of its ongoing balance-sheet reduction could be adjusted in line with underlying economic conditions.
As a side effect, a more dovish Federal Reserve also makes life a bit easier for vulnerable emerging markets that continue to recover from their 2018 adjustment crisis to the stronger US dollar.
Meanwhile, other major central banks, including the Bank of Japan, the European Central Bank and the Bank of England (which is tackling its own local uncertainties linked to Brexit) have turned suitably dovish.
In the absence of serious inflation risks, central banks can focus on keeping demand growth on track and leaning against any drop in financial market sentiment that poses a threat to the underlying real economy.
The true acid test of the central bank ‘put’ will come when inflation starts to rear its ugly head.
Luckily for central banks, and markets, that seems to be a very remote prospect indeed.
Kallum Pickering is senior economist at Berenberg Bank
This article was taken from the Cash Management Edition 2019 issue of The Treasurer magazine. For more great insights, log in to view the full issue or sign up for eAffiliate membership