SUMMARY ASSET ALLOCATION
Since the volatility after June’s UK referendum, financial markets have been eerily quiet. The VIX index, which measures volatility in US equities, has fallen to close to a record low. In Europe, volatility has been somewhat higher, which is probably mostly due to lingering political risk.
Developed equity markets have recovered from their Brexit dip and have lately trended sideways to slightly higher. Emerging markets have done better: they are up
by almost 30% from their January dip, in US dollar terms. Apart from the outlook for growth and earnings, which we see both as mediocre, we think monetary policy and the outlook for emerging markets are the key factors for today’s investment climate.
Just one rate hike in the US or two after all?
Several Federal Reserve policymakers have lately hinted at the possibility of an imminent interest-rate rose, however, without being very precise on the timing. They see US inflation and the labour market as getting closer to the Fed’s targets of 2% inflation and full employment. Developments in the labour market have actually been more convincing: the unemployment rate has fallen to below 5%, a level thought to be low enough to start generating wage gains and inflation. However, estimates of where this level actually is have fallen over time. Some signs of wage pressures have started to emerge, but inflation is still well off the Fed’s target. The core PCE deflator has been stuck at 1.6% for five months through July and has slowed to 1.4% on a three-month annualised basis.
Still, in a closely-watched speech at the Fed’s annual Jackson Hole conference, Fed chair Yellen said the case for higher rates had strengthened in recent months. An interview with Fed vice-chair Fisher had an even greater impact. He said Yellen’s comments were consistent with the possibility of two rate hikes this year.
We think there are several preconditions for a rate hike. Of course, the economy and the labour market should be strong enough. Growth was dreadful in the first half, but with the drag from inventories fading, the second half should be better. Probably not stellar, but strong enough. However, the labour market report for August, published in early September, in our view did not seal the case for a rate increase this month since employment growth slowed as well as the growth momentum in hourly earnings. Equally, we believe the Fed cannot be confident that inflation is approaching its 2% target. It sees low headline inflation (0.8% on the PCE deflator) as mainly driven by low energy prices and (now passed) US dollar strength. Indeed, both effects should be transitory, but as mentioned, core inflation has been stagnant for a while. The third precondition would be that markets should at least partly discount a rate hike. The recently more hawkish Fed comments had pushed up the market-implied probability of action at this month’s policy meeting to just above 40% in late August and the odds of at least one rate hike in December had jumped to above 60%. The likelihood receded somewhat after the August labour market report and with the sudden drop into contraction territory of the ISM manufacturing index signalling a weakening of producer confidence.
A low probability could keep the Fed on the sidelines since it does not want to surprise the markets. Whether the current market probability is still high enough for the Fed is a close call, in our view.
At this point, we expect the Fed to opt to wait until December. The latest comments had been aimed at preparing the ground for a hike this month, but now there appears to be no need to rush. Although the Fed gradually wants to normalise rates to prevent financial instability from developing, its room to manoeuvre is limited. The ‘neutral’ fed funds rate, the level above which rates would start to cool down the economy, has fallen over time, which makes current monetary policy less accommodative than when this ‘natural’ rate is high. Moreover, the ECB may soon announce additional stimulus measures.Download to read more