In recent months, muted or adverse market reactions to central bank action reflected investor doubts about the impact of monetary policy. But the latest, dovish, comments from Janet Yellen, chair of the US Federal Reserve, have lifted equity markets and sent bond yields lower. Obviously, the Fed still matters for markets. So it will be interesting to see how other central banks react.
YELLEN DELIVERS DOVISH COMMENTS
As said, the Fed chair’s speech at the Economic Club of New York was decidedly dovish. Yellen described the economy as somewhat mixed since the turn of the year and stressed downside risks such as the modest pace of global growth, developments in China and the prospects of commodity prices. The inflation outlook has become more uncertain due to the risks to the growth outlook and falling inflation expectations. Yellen is not convinced the rise in core inflation will last.
We would agree with some caution on inflation given the lack of wage pressure in the domestic labour market and the disinflationary pressures from abroad. Yellen repeatedly stressed that this constellation calls for gradual increases in interest rates. What is clear to us is that she wants to see more stable global markets and commodity prices and does not want an overly strong US dollar.
Why did she decide to sound so dovish? Fed forecasts for policy tightening had already been toned down and markets saw even less of a need for higher rates. It could be that Yellen felt the Fed should be even more dovish, but that would be a sudden change shortly after the most recent FOMC meeting. It is more likely that she wanted to show leadership after other Fed officials had recently argued for rate increases, even as early as April. It is clear that she does not favour an early hike.
As opposed to other policymakers, Yellen may have a more global perspective, especially when it comes to inflation. Looking just at the Fed’s objectives – low unemployment and inflation at around 2% – one could easily argue for higher rates. But even the current 4.9% unemployment rate has not sparked inflation. Yellen said that the Fed may have overestimated the longer-run unemployment rate which would trigger inflation. This would support her gradual approach to policy tightening.
We believe a hike in April is virtually off the table, but action in June is still possible. Increasingly, it looks like there will be only one move this year.
US DATA: MIXED
As said, Yellen sees a mixed economy, which is clear in the recent data. Weakness in the manufacturing sector due to the strong US dollar and an inventory correction were confirmed by weak durable goods orders and shipments. Business investment in equipment and software looks unlikely to improve in the first quarter, but to some extent, this could be offset by a stronger services sector and higher consumption.
Consumer confidence improved in March, but consumers continued to be hesitant in their spending, preferring to save some of their income gains. This should keep growth low for now, but it is actually positive from a longer-term perspective. So consumption should continue to support GDP growth, even though the indicators so far suggest that growth will be below trend in the first quarter.
IMPROVED CREDIT GROWTH IN THE EUROZONE
The Economic Sentiment Index disappointed in March, but still points to growth of around 1.6% YoY, matching that of the fourth quarter. The index has now fallen for three months in a row, possibly in a normalisation from overly optimistic levels, but this is something to be watched closely.
Our relatively optimistic view on the eurozone is based on tailwinds such as cheap oil, the low euro and less austerity. Some of these supports should fade over the course of the year. Oil has reversed some of the declines, as has the euro. Consumption could take over, helped by the gradual fall in the unemployment rate. But it is disturbing to see consumer confidence weakening this year.
On the credit side, there is support from low yields and lending rates. Lending is no longer a drag on growth and the recent increase in monetary policy support from the ECB should help. Enabling banks to borrow from the central bank and get interest paid should give lending another boost.
BRAZIL’S PROBLEMS DEEPEN
Brazil is mired in a deep recession, partly due economic mismanagement and a political crisis which has taken the government coalition to the brink. The lack of reforms and excessive credit growth have come to haunt the economy. The debt-to-GDP ratio has more than doubled and personal loan delinquency has surged lately. Consumer confidence has fallen to close to record lows, the unemployment rate has jumped, the fiscal deficit seems out of control and rising interest payments are limiting the central bank’s ability to contain inflation.
Still, Brazilian equities have done exceptionally well recently. Of course, the slight rise in commodity prices benefits commodity producers. Markets may be discounting political change and a more business and reform-friendly government, but we think the market may have gotten ahead of itself.
In terms of private debt relative to GDP, Brazil ranks seventh out of the 18 emerging economies we track. Argentina looks best. Brazil looks more vulnerable when looking at the increases in debt and debt service levels.
ASSET ALLOCATION: STEADY
Obviously, Yellen’s speech affected market sentiment. Equities gained globally, US bond yields fell and the US dollar weakened. It looks like ‘Goldilocks’ is back: the global economy is growing, inflation is low and monetary policy is supportive. The Bank of England said it wants to raise banks’ countercyclical capital buffers as the outlook for financial stability in the UK has deteriorated, but the BoE will likely move cautiously and the rules will not be binding before March 2017.
Another Chinese company defaulting on its bonds had a limited impact. The main question is how many defaults the government will accept, also in the face of the overcapacity problems and the need to close capacity in some sectors. It is far from clear how much short-term pain the authorities are ready to accept. Recent comments show that this may be limited.
The rally in commodity prices and the weaker US dollar have supported markets. In percentage terms, the rally in oil prices is quite impressive: almost 50% from January’s low. We do not see a lasting rally in commodity prices though given the ample supply, limited demand growth and high inventories. We prefer to stay neutral.
We have kept our underweight in global equities, preferring to be underweight in the eurozone. Superficially, it may look like the global economy is in a ‘Goldilocks’ scenario, but the risk of low inflation makes it hard for companies to increase earnings since cost-cutting could hurt labour markets and consumer demand. Given such risks, we think that the recent equity rally is overdone.
Government bond yields fell after Yellen’s comments, but if the Fed remains on course for two rate increases this year, there could be upward pressure on yields. This should be limited given the low yields in Germany and Japan. The ECB’s asset purchases may be a formidable force against rising yields. In Japan, recent market developments may lead to further action: equities fell as the yen rose. A further increase in the consumption tax in April next year might trigger additional – pre-emptive – monetary easing.
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