The Federal Reserve should do the right thing
The market turbulence experienced at the end of last year had much to do with investor’s perceptions of the impact of the US Federal Reserve’s monetary policy stance on the US and international economic outlook.
As we headed into December there had already been evidence that the interest rate sensitive areas of the US economy, notably housing and auto sales, had been weakening. Whilst in overall terms economic growth remained solid these cyclically sensitive sectors had been flashing warning lights to investors. Nonetheless, at its December monetary policy meeting the Fed hiked its Fed Funds rate by 0.25% to the 2.25%-2.50%, reduced its central guidance for 2019 from three to two rate hikes – but still pencilled in an additional hike in both 2020 and 2021. In the round, this guidance remained well in excess of market pricing (which stood at one more rate hike for this cycle).
Whilst there was some recognition that the international economic environment was less robust, the Fed still appeared to signal that it remained on a course of further policy normalisation, leaving the markets fearful that it may be about to commit a major policy error. Historically – and generally with the benefit of hindsight – economic and market cycles have often been ended by central banks tightening policy too much and, the market is currently hyper-sensitive to a repeat of this playbook, with recent evidence of subdued underlying inflation pressures further underlining this.
In early January, Fed chair Jerome Powell, in a marked change of stance, addressed the market’s concerns that the Fed could be about to commit the cardinal sin of tightening into a slowdown. He stressed that the Fed was not on a predetermined path to higher interest rates and that the evolution of domestic economic data and the global economic and financial market environment will be the key drivers of its policy stance. Looking ahead – and unless the domestic US and global economic outlooks brighten markedly – we believe the scope for further US rate rises now looks limited. If we are correct in our view that the Fed ultimately does the right thing by pulling its punches, then markets are in all likelihood overplaying the bear case for equities and that we are likely to see reasonable stock market performance during 2019.
Notwithstanding the recent downshift in global growth expectations there has been some positive news in recent weeks. The longstanding impasse between the Italian coalition and the European Commission over the proposed Italian budget for 2019 and beyond appeared to be resolved in a good old fashioned fudge and there were further signs of thawing in the trade dispute between the US and China with bilateral talks commencing in January. Elsewhere, the rally in the Dollar has run out of steam for the time being and taken together with the sharp fall in the oil price the pressure on a number of emerging market countries to combat inflation by tightening monetary policy is now much less, thereby supporting the regional growth outlook.
As we progress through the first quarter, the focus will turn to the corporate earnings reporting season. In the US 2018 is likely to see full year earnings growth in excess of 20% (significantly boosted by tax cuts and share buybacks), and whilst 2019 growth is likely to be somewhat lower, given that the markets all but discount an earnings recession there is a reasonable amount of scope for some positive surprise.
Lastly, the recent selloff in equities and decline in bond yields has pushed global equities to their cheapest level relative to investment grade bonds for many years. If we turn our attention to the UK for a moment, the comparison is even starker – the FTSE100 now yields 4.9%, which is a record premium to the ten-year gilt yield of 1.2%. For those investors who have a long-term time horizon, now is a good time to consider overweighting equities to bonds.