Central Bank Divergence

Economic Growth and Inflation

As global central banks take different paths, where might investors look?

In the never-ending task of encouraging economic growth and dampening inflation, in recent weeks the world’s major central banks have taken different rate action. Some hiked, some paused and one cut. At the heart of the matter is inflation, whether too high or too low. For those in countries with substantial price pressures, the job is particularly precarious as efforts to quell inflation historically restrict growth. 

 

What should investors take away from the diverging monetary policy? Asset allocation matters more than broad economic direction. Over the last decade, U.S. equities dominated and diversification detracted from performance. That could now be changing. Economic growth around the world likely won’t be as highly correlated as the last decade. 

 

Looking around the world, we still favor high-quality, leading companies with well-defined growth plans in secular growing industries. Dividends are key, and we expect equity returns to trend toward their long-term averages.

 

Here’s a closer look at the action the largest global central banks have taken recently:

 

Up

 

  • The Bank of England Similarly spooked by the May inflation report of 8.7%, it surprised markets last week by raising its benchmark rate by 50 basis points 5%. The markets project it will lift rates as much as another percentage point by early 2024. Consumers are also facing untenable growth in food prices surpassing 18%. Another problem arrives as homeowners whose mortgages reset in the second half of this year—potentially more than 800,000—will have sticker shock as rates have tripled since March of 2022. 
  • European Central Bank Over the last two quarters eurozone GDP growth has been negative. Nonetheless, in mid-June the bank increased interest rates to 3.5%, the highest level in more than 20 years. After President Christine Lagarde said another hike was “very likely” in July, markets reacted by pricing in an 80% probability rates reach 4% by October. While eurozone inflation grew slightly less in May than in April, at 6.1% annualized, it is still well above the central bank’s 2% target. It is a parallel story with food inflation, which cooled from a red hot 17.5% in March to a still scorching 13.7% in April. 
  • Bank of Canada Earlier this month, policymakers defied expectations by restarting their tightening campaign, saying the economy is running unacceptably hot. They raised the overnight lending rate to 4.75%, the highest level since 2001, noting that “excess demand in the economy looks to be more persistent than anticipated.”

 

Steady 

 

  • Federal Reserve While the Fed took no action at its mid-June FOMC meeting for the first time in 10 meetings, you might group it with the above. That’s because a hawkish tone was struck when policymakers forecasted that the median fed funds rate would reach 5.6% by year-end, suggesting two more 25 basis-point hikes. Their rationale is that the core inflation could be higher than previously forecast, potentially hitting 3.9% by the end of 2023. It remains to be seen if any additional hikes will dampen aggregate demand enough to restrain inflation and avoid a recession.
  • Bank of Japan Maintaining its view that inflation will slow over the coming months, the central bank decided to keep rates negative (-0.1%) and not alter yield-curve controls. The yen responded by falling to near a 7-month low. While inflation grew 3.5% in April, Governor Kazuo Ueda remains more concerned with deflation, warning that premature tightening could derail the progress being made to combat that. But speculation has begun on whether the bank will tweak its yield-curve controls at its next meeting in July.

 

Down 

 

  • Peoples Bank of China A notable exception is China, where policymakers are focused on economic growth not inflation, evidenced by cutting a key policy rate by 10 basis points to 2.65%. China’s economy has not seen the growth they expected after the end of its Covid restrictions. More easing is likely as the central bank looks to stimulate the economy.
DISCLOSURES
 

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Past performance is no guarantee of future results.

Prices of emerging markets securities can be significantly more volatile than the prices of securities in developed countries and currency risk and political risks are accentuated in emerging markets.

The value of equity securities will fluctuate and, as a result, the investment’s share price may decline suddenly or over a sustained period of time.

International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards.

Federated Advisory Services Company

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