Recently we have witnessed a shift in rhetoric from the Federal Reserve (Fed), with chairman Jerome Powell saying it would like to see a further increase in labour force participation and it increasingly appears as though the Fed would like to see higher wages feeding into inflation before returning to its tightening bias.
We expect this change in policy stance to underpin risk markets and provide a boost to activity over the next two to three months. Softening global growth, particularly in the euro area and China, will continue to validate the Fed’s shift. In the US, growth remains around trend and labour markets remain extremely tight, with Chart 1 below highlighting that there are now more jobs than available workers.
We believe the Fed will get what it wants and this pause in tightening will prove to be “the pause that refreshes” rather than the end of the tightening cycle.
Chart 1: Limited spare capacity in the US economy
Risks to near-term growth still very much stem from China, with trade tensions having thrown grit into the smooth functioning of the global economy. The import component of the China PMI index has bounced modestly, whereas the Caixin / Markit Manufacturing PMI index is still pointing to much lower US manufacturing, in our view.
Inflation indicators also appear supportive to the Fed’s aim – according to consumer price index (CPI) data headline inflation in the US is set to decline over the coming months. The oil price and CPI number remain closely correlated, and recent falls in oil suggest to us headline CPI will near 1%. However, underlying price pressures are rising: lower oil prices will likely drive consumer spending and we believe there is another underlying inflation story brewing – that of an acceleration in wage gains.
And it is wages, adjusted for productivity, which are the primary driver of medium-term US inflation in our view. If productivity growth does not pick up sharply within the coming months – and there are few signs of this – the Fed may see the base effects from lower oil prices drop out, probably around mid-year, and underlying wage pressures impacting. Therefore, unless the US economy slows unexpectedly, we believe the Fed will have to resume its tightening bias.
From an investor perspective this is particularly worrying, because this is not what markets appear to expect. Investors have been quick to take on the Fed’s revised message and modest rate cuts are now priced for the US by Q1 2020.
Looking ahead, China and the euro area appear more vulnerable than the US. However, China has been easing policy (1% of GDP in 2018 and 1% expected for 2019) and the latest Fed action will help further. Meanwhile, growth in the euro area is still declining and obvious risks remain, but recent policy actions from the Fed and the Chinese should put a floor under activity; given still very accommodative policy we suspect that the worst of the growth slowdown is behind us.
Some of the exogenous risks, in the form of a prolonged US government shut down and trade wars, are also expected to diminish. In particular with China we sense a real commitment, with Chinese leader Xi JinPing meeting US Trade Representative Robert Lighthizer and Secretary of the Treasury Steve Mnuchin before meeting President Trump. Any easing in US / China trade tensions will provide an obvious boost, in our view.
So while global growth may be respectable this year, as 2018 bore witness, with the Fed withdrawing liquidity and the European Central Bank (ECB) and Bank of Japan (BoJ) no longer adding liquidity, the prospects for asset markets are likely to remain more uncertain than usual in our view.
The fixed income market is already pricing in rate cuts and will likely be faced with a massive increase in supply and rising underlying inflation. At the same time Fed holdings in fixed income assets continue to fall by USD 50 billion a month – USD 30 billion in US Treasuries and USD 20 billion in mortgage assets. Equities, meanwhile, look expensive on a cyclically-adjusted price to earnings (P/E) basis. With Q4 earnings almost complete, 70% of companies are beating expectations, down from 90% in Q2 and 80% in Q3. Earnings are decelerating quickly, from 28% year-on-year in Q3 to 16% in Q4. Credit is also not cheap. Since quantitative easing (QE) we have observed a structural shift towards holding higher levels of credit – evidence of a yield grab. But beneath the surface we have the highest amounts of corporate debt in history alongside the highest leverage ratios outside of recessionary periods. At the same time Moody’s covenant quality index is close to its all-time low. While the scale of investment grade debt has more than doubled in the past decade, BBB assets have quadrupled.
Perhaps the key observation at the core of our thinking is that returns to labour are on the up, after years of real wage falls, while returns to capital will likely face an increasingly challenging environment.
Faced with an environment where many traditional markets are expensive and the direction of monetary policy will be tighter after this temporary reprieve from the Fed, we believe it is essential for investors to diversify away from beta / risk and increase their allocations to uncorrelated / alpha-seeking strategies.
While some of these alpha-oriented strategies may have found the past few years challenging under the distortionary effects of QE, we believe that tide is now turning. As it does, so fundamental drivers and valuations are likely to become more important drivers of returns. There will still be exogenous shocks and random tweets to navigate, but in our view that is all the more reason to focus on liquid strategies which are less beta dependent.
There are a number of themes which currently interest us. The US yield curve looks too flat, in our opinion; the Fed has been slow to move and wants to see inflation coming through. UK fixed income is expensive, meanwhile, with investors not being compensated for their risk. In Mexico, we believe falling inflation should support rates – they are currently at or close to peak; while weak private credit growth and a more stable peso and oil price suggest CPI could fall as the year progresses. The Norwegian krone has been cheap for a while but growth remains solid and CPI is above target; the Norges Bank’s plan to hike rates in March separates it from the pack. Finally, US and Swedish swap curves are showing extreme divergence; the Swedish krona has so far not responded to economic conditions in the way we would have hoped but we still expect this move to come through albeit more slowly than previously expected.