With positive and negative days alternating, the S&P500 equity index has moved broadly sideways in recent weeks. It is still resilient despite the recent disappointing data, slowing inflation and the Federal Reserve raising US interest rates. Bond markets have taken the recent growth and inflation slowdown more seriously, with yields trending lower and the yield curve flattening. Eurozone equities had struggled more, but the French parliamentary elections result with President Macron’s party winning a majority has fed a rally with French equities outperforming the other major European equity markets on hopes for structural reforms.
MARKETS SMELLING A POLICY MISTAKE…
Recent economic data has clearly disappointed in the US. Our economic surprise index has fallen by two thirds of a standard deviation below its average. A look at the speed of the decline and historical patterns suggests the index can fall further. In the past week retail sales came in much weaker than expected, although upward revisions to earlier months sweetened the pain. Housing construction data was also weak, while consumer confidence has given up half of the post presidential election gains. And of course inflation has disappointed too, with core inflation at its lowest in two years. There were more positive regional indicators of producer confidence, but the gap between optimistic survey data and more downbeat hard data is not closing so far.
So, is the Fed making a policy mistake? In recent months, when raising the federal funds rate, the US central bank had clearly banked on an important lesson from the prior two economic expansions: that the unemployment rate cannot remain indefinitely below the NAIRU rate, the long-term equilibrium unemployment rate, without triggering higher inflation. Today’s policymakers remain firmly fixed on this lesson. Repeatedly in recent years, Chair Yellen has warned of the risk of waiting too long to remove policy accommodation. Interestingly, the Federal Open Market Committee has cut its estimate of the end-2017 unemployment rate (indicating further labour market tightening), without raising the outlook for inflation. It would seem that the NAIRU is also drifting in the minds of policymakers.
On top of the latest 25bp rate rise, the FOMC provided significant detail on the process for unwinding the Fed’s trillion-dollar balance sheet, using gradually increasing caps. The caps will initially be set at a relatively low USD 6 billion for US Treasuries and USD 4 billion for mortgage-backed securities (MBS). They will be raised by these amounts every quarter until they reach USD 30 billion for Treasuries and USD 20 billion for MBS. The relatively low starting amounts, as well as Chair Yellen’s comment that balance sheet run-off could begin ‘relatively soon’, suggest to us that the Fed is targeting a September start date.
By focusing on this longer-term inflation risk, the FOMC increasingly faces scepticism among investors about the symmetry of the Fed’s inflation objective – two percent inflation may in practice turn out to be a ceiling. With policymakers looking through the softness in recent inflation data and projecting 175bp more of policy tightening by end-2019, we would not at all be surprised to see markets trade a ‘(hawkish) policy error’ narrative in the coming weeks. If so, bond yields would fall, yield curves would flatten and risk assets could come under pressure.
If inflation pressures indeed remain modest, the FOMC will signal a need to reassess the inflation and policy outlook relatively quickly, bringing the ‘policy error’ trade to an end. Central bankers can be expected to acknowledge that continuing to tighten policy in the face of very muted inflation would risk the Fed falling short of the inflation target of its dual mandate.
…BUT NOT BY THE BOJ
While we do not see a policy mistake by the Fed as a major risk, that risk is even smaller in Japan. The Bank of Japan recently left monetary policy unchanged and governor Kuroda is not even willing to discuss any changes as long as inflation is below the central bank’s 2% target.
AND THE ECB?
While we doubt the Fed will deliver on its fairly hawkish outlook of one more rate rise this year, followed by at least three more next year, as well as a reduction of its QE-inflated balance sheet, the problem for the ECB is that it looks set to run out of eligible bonds to buy under its QE programme soon. Thus, it will have no choice but to taper its asset purchases. In our base case scenario, the data will be just strong enough to enable the ECB to start tapering, but there is a risk of forced tapering without this being backed up by solid growth and inflation.
The voting in the latest UK policy-setting meeting surprised as three members supported a rate rise, while five members voted for no change. Data is pointing to slowing growth, but inflation has accelerated, admittedly mainly on the back of the pound’s depreciation. With one of the hawks set to leave the policy committee soon, we see little risk of an actual tightening.
BOND MARKETS MORE CONVINCED THAN EQUITY MARKETS
Bond markets look more convinced of the possibility of a monetary policy mistake than equity markets. US yields have fallen to below the trading range established after last November’s US presidential election. At that time, 10-year yields had stood at 1.8% before peaking at 2.6% in March. Now they are back at 2.1%. So it seems that some of the reflation story is still alive. German 10-year yields remain in their trading range, but the spread over two-year yields has now narrowed to 15bp below the average since late last year.
Inflation expectations as reflected in swaps and inflation-linked bond markets have come down. A flattening yield curve can be an indicator of a recession coming, but we do not think this is imminent. The slope of the yield curve is still positive and credit spreads are still tight.
That could be why equity markets have been so resilient recently, even given the lofty valuations, especially in the US, challenging earnings expectations and disappointing economic data. Eurozone equities are benefiting from fading political risk, especially after President Macron’s victory in the parliamentary elections. A more positive investment climate in the eurozone and continuing political disarray in the UK should benefit our overweight in eurozone equities versus UK equities.
ASSET ALLOCATION: UNCHANGED
Yes, developed equities are overvalued and earnings expectations may be too high, but equities have proven resilient amid less positive news on growth, inflation and monetary policy. On monetary policy, this may actually be as hawkish as central banks will get for now. But for equity markets to keep grinding higher, we believe a new narrative is needed. That could come in the form of the next round of earnings reporting, but we are somewhat cautious. Hence our neutral position.
We are structurally short duration since we think that bond yields are low given the consensus expectations for muted GDP growth and inflation in the major markets. We would tend to take tactical positions around this structural short when we expect short-term up or down-trends in yields. At the moment, we have no such position.
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