JACKSON HOLE: WHAT WAS SAID AND WHAT WAS NOT
Yellen’s outlook for the economy was not much different from what we have heard before: it is expanding and the labour market is improving. She hinted that the case for an increase in the federal funds rate had strengthened in recent months. Financial markets’ overall interpretation was that of a dovish tone: about half of Yellen’s comments on the outlook were dedicated to uncertainty and the Fed’s limited ability to predict how rates would evolve. In other words, markets saw a case for higher rates, but no need for immediate action.
But when Fisher said that Yellen’s remarks were consistent with one or even two rate increases this year, a hawkish view took hold and market sentiment turned. US equities fell, ending another week on a slightly negative note, and US bond yields rose. While a stronger US dollar (and thus a weaker Japanese yen) supported Japanese equities, emerging equities suffered. One rate hike in September or December should actually not make too much of a difference, but the prospect of two increases this year would require some repricing of assets.
ONE US RATE RISE LOOKS PROBABLE
At this point, the market-implied probability of a rate increase in September stands at 42%, more than double the 20% seen two weeks ago. One rate rise in December now has a 65% probability, but for two hikes this is only 17%. We think the market’s view on the probability of a rate increase in September is now strong enough to make this a viable option for the Fed in the sense that a rate increase is now well priced in and markets would take the actual move without too much tumult.
Much will depend on the upcoming data releases, especially the labour market report for August. If this shows a third straight strong gain – the Bloomberg consensus is currently for 180 000 jobs to have been created – the Fed would be virtually boxed in for a September rate increase. Whipping up expectations for a hike again without acting, as the Fed did in July, would hurt the central bank’s credibility.
NEGATIVE RATES: NOT FOR THE FED
Talking about monetary policy tools, Yellen did not signal any imminent changes. The ability to pay interest on excess reserves held by banks at the Fed enables the central bank to create liquidity without interest rates dropping by too much and asset purchases and forward guidance about interest rates enable the Fed to stimulate the economy if necessary. We think Yellen put up a brave face here. Asset purchases and forward guidance are less effective if Treasury yields are low, as they are now.
There was no mention of negative interest rates. We think this shows the Fed’s reluctance to go down this path. Yellen basically left this topic to Bank of Japan Governor Kuroda and ECB Executive Board member Coeure.
JAPAN: LIMITS FOR BOJ IN SIGHT
The latest inflation data underscore the need for further action in Japan. Headline inflation fell to its lowest in more than three years. Excluding fresh food and energy, core inflation slipped to 0.3% in July, well below the BoJ’s 2% target. The data for Tokyo, which includes August, did not show any improvement with headline inflation holding at -0.5% and core inflation slipping to just 0.1%. The BoJ will review its policy comprehensively at its September meeting and Kuroda has not ruled out taking interest rates further into negative territory. An in-depth review would imply more than just a step-up of current policy, but we think the BoJ’s options are limited.
MIXED ECONOMIC DATA
US GDP growth was slow in the second quarter, while the first estimate of corporate profits in the national accounts showed another quarter with falling profits. With a brief interruption in the first quarter, total profits have fallen since the first quarter of 2015 on a quarterly basis. Margins – profits as a percentage of GDP – have been falling since the second quarter of 2014. Of course, this is partly due to the steep declines in profits in the energy sector, but modest nominal growth, low productivity growth and higher wage costs have weighed on margins. The risk for the economy is that companies start cutting wages. In fact, growth in employee compensation has slowed in the past few quarters.
Housing looks like less of a risk for US growth. Although the recent strength in new home sales looks overdone as it was driven by price discounts and was regionally concentrated, low mortgage rates and growing employment are supportive. As home sales move sideways and supply fall, there could be further price gains.
PMIs in the US disappointed slightly, clouding the expectations for a growth rebound in the second half. However, durable goods orders improved. In the eurozone, the PMIs were quite resilient. The composite index for the region increased with steady growth in manufacturing and services. However, in Germany, the composite PMI fell due to a slowdown in services. More importantly, the Ifo index showed the biggest decline in four years. This may be a reaction to the Brexit vote, which we expect to have a limited impact on the eurozone economy as a whole. We would also interpret the decline in business sentiment in Italy in this way.
UNDERWEIGHT EQUITIES WITH A HEDGE
We are underweight developed equities versus cash since we think equities are slightly overvalued, while the economic outlook looks clouded. Negative yields on many developed government bonds are pushing investors into higher yielding and riskier assets, including corporate bonds, emerging market debt and even equities. But we regard the earnings outlook as negative and we also foresee further downward revisions to analysts’ earnings estimates.
We regard our overweight in US small-cap equities versus large caps partly as a hedge against our underweight in equities. But we also think that the earnings outlook for small caps has improved and that mergers and acquisitions are positive for small caps.
We are underweight hard currency emerging market debt versus US government bonds. Risk spreads have narrowed, but we think emerging market debt and equities are discounting a swifter-than-likely recovery. Related to this, we are underweight commodities.
IN BONDS, TREASURIES AND INFLATION-LINKED
In government bonds, we prefer the US over broad eurozone government bonds. Yields are higher in the US and the steeper curve provides additional returns. We still see growth and political risks in some ‘peripheral’ eurozone member states.
We prefer eurozone inflation-linked bonds over nominal government bonds. Inflation expectations embedded in this asset class are extremely low. In fact, we think inflation-linked bonds have overshot. Higher headline inflation due to base effects (as last year’s fall in energy prices drops out of the calculations) could trigger higher inflation expectations.