After a generally positive quarter, time for a reality check?

Is the Fed getting ready for the next step in unwinding loose policy?

03 Apr 2017

  • Purchasing managers’ indices: have we seen the peak?
  • US Federal Reserve sounds more hawkish, ECB is less clear
  • Market optimism not broken
  • Asset allocation: cautious and defensive

The first quarter was generally positive for risky assets. Global equities rose, with emerging markets outperforming developed equities and Europe slightly ahead of the US and Japan. The US dollar lost some ground to the euro. Within equities, the information technology (IT) sector stood out; industrials and consumer discretionary did particularly well in emerging markets. High-yield corporate bonds and emerging market hard currency debt did better than investment-grade or government bonds. Commodities declined, led by crude oil.

The quarter saw strong producer and consumer confidence surveys, which led the rally in risk assets, despite political uncertainty. In our view, the result is even richer valuations in many asset classes. The widespread rise in inflation, which affects consumer behaviour and central bank policy, is another reason for us to guard against excessive optimism.



Details of the purchasing managers’ indices (PMIs) confirmed the positive picture in the eurozone: manufacturing PMIs improved in France, Germany and Italy. But the US manufacturing PMI fell for the second straight month, while Japan also declined. There is no uniform picture in emerging markets either. Turkey saw a jump, which was surprising given the political uncertainty in the country and the region. In Russia the PMI has been above 50 since oil prices have started to rise. In Mexico manufacturing confidence has been supported by the weak, but stabilising peso. Confidence in India has recovered quite quickly from the flurry caused by demonetisation when a large chunk of liquidity was withdrawn from the economy. In China the official manufacturing PMI was marginally higher, while the services sector index rose to its highest in almost two years. However, the Markit manufacturing PMI slipped. The South Korean manufacturing PMI fell further below 50, signalling a loss of momentum.

The overall picture? Some of the excessive optimism may be fading, especially in the US. Obamacare was not repealed, but the initiative to do so is not dead, in our view. The Congressional tussle over the repeal could have consequences for tax reform in the sense that any cuts may be significantly smaller than promised during the election campaign. Economic growth should be muted for the time being. Yes, consumer confidence may be high, but real disposable income is estimated to be up by only 0.6% QoQ annualised in the first quarter. Real consumption has fallen recently. In addition, there is lingering weakness in corporate profits, which does not bode well for business investment.

The eurozone outlook continues to be quite solid, but we still expect slowdown in China as monetary stimulus is taken back gradually and fiscal stimulus may be fading. This tempers our optimism about Asia, although there have been green shoots in trade and industrial production.



For the Federal Reserve, it looks like mission accomplished: US inflation is running above its 2.0% objective for the first time in almost five years. As of February, the PCE deflator was already at 2.1%. Looking at core inflation, which perhaps provides a better sense of underlying trends, this is looking solid: the index has risen at 2.5% YoY over the past three months.

So what’s next for the Fed? Running off its billion-dollar balance sheet soon? Vice-Chair Dudley commented that sometime later this year or in 2018, should the economy perform as expected, the securities on the balance sheet would be allowed to mature rather than being reinvested. Sometime later this year is earlier than most investors had expected so far. There would be a gradual and predictable tapering of the reinvestment policy to mitigate the risks of an undue tightening in financial conditions and possibly a pause in raising policy rates when runoff begins. From these and other comments, we take it that the Fed prefers to rely on interest-rate policy as its main tool, with balance sheet runoff largely on auto-pilot. We expect runoff to be announced in December and for it to begin next January.



Underlying inflation is weak in the eurozone. Headline inflation slipped back to 1.5%, with price increases in energy and unprocessed food easing. To be fair, changes in the timing of Easter are playing the usual havoc with the YoY changes in some of the more seasonal items, so inflation is likely to spike next month. The overall message seems clear enough: the boost to headline inflation from food prices is fading.

This week there was more of a concerted effort to realign expectations around the ‘taper pause hike’ strategy the ECB is forecast to follow when it ends its quantitative easing (QE). But executive board member Benoit Cœuré stressed that any decision would hinge on the assessment of the inflation outlook, so there appears to be no agreement that the deposit rate will not be raised until QE is over. We think Cœuré is speaking for the few and not the many, but you cannot rule out a small increase in the deposit rate in the second half of the year, perhaps to appease the protectionist Trump administration.

The president of the Dutch central bank, who has been one of the perma-hawks on the governing council, said tapering should begin as soon as possible after the current guidance on asset purchases expires in December because the grounds for the QE programme had disappeared. He argued that the process of tapering could be completed in five months, with the pace of asset purchases being reduced by EUR 10 billion per month. Finally, he supported tapering QE before raising rates. This makes sense if you believe that the hawks on the ECB council are most concerned about the moral hazard aspects of ultra-loose monetary policy on politicians, which operate predominantly via QE (as opposed to negative interest rates).



Amid low volatility, equity markets managed to grind higher in the past week. We think markets are looking at the bright side of things. Positive surprises in economic data have been clearly driven by soft data such as surveys of producer and consumer confidence. It looks as if equity investors are taking the view that the hard data and corporate earnings should follow. We are less sure. Earnings momentum has improved in emerging markets, but it has slowed in the US. Optimism in earnings revisions has been broader based, but it has not been strong enough to improve valuations. We believe equities are somewhat expensive, especially given the risks we see such as a growth slowdown in China, protectionism or higher inflation and bond yields.

Bonds have clearly stuck to the modest hard data. US and German yields have retreated in recent weeks. Looking through the short-term volatility, spreads on corporate bonds and emerging market debt have remained low. Oil has bounced back from a three-month low.

Thus, the optimism in financial markets has not been broken by recent events and data. But given our more modest view on the economic outlook and the rich valuations in many asset classes, we have maintained our cautious stance in the overall asset allocation.




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