It is just a few weeks since the US Fed raised interest rates and central bankers globally opined on a removal of monetary accommodation (albeit slowly) as the global recovery gathered momentum. Unfortunately, some inconvenient facts are already casting their shadow. The Atlanta Fed US GDP nowcast for Q2 17 has fallen to 2.4% from 4% at the start of June, with disappointing US retail sales contributing to the downgrade. Furthermore, core CPI has undershot expectations with the year-on-year figure now at 1.7% for June, compared to 2.3% at the start of the year. Fortunately for central banks, the holiday season has started and the focus may be elsewhere. However, some re-calibration of the trajectory of US monetary policy may already be necessary.
During 2017 the US Fed has steadily increased the volume in respect of its concerns over financial instability (i.e. the apparently low level of current risk premia in credit and equity markets) even as the dual mandate of the US Fed is to maintain maximum unemployment and stable real economy prices.
In fact the predominant policy lever in respect of financial instability risk is prudential regulation of the banking sector rather than monetary policy. In this regard Fed policymakers believe significant progress has been made and a decline in asset prices would not necessarily have systemic implications – something which should on its own put investors on guard.
There is even currently something of a consensus amongst investors in respect of the possibility of the Fed tightening policy monotonically and as a result creating a crisis in equity markets in the second half of this year if the economy slows. We certainly share the view that equities are expensive on global basis and notably in the defensive and technology sectors where investors have been starved of yield and growth stories respectively.
We also share the view that the Fed in particular would like to normalise policy while the US economy is growing, in part due to rising asset valuations, or in other words currently has a bias to tighten. Other central banks also appear to be moving in the same direction.
However, while we agree that this current bias to tighten represents something of a near-term ceiling on risk assets such as equities, fears of a dramatic fall in markets require central banks to commit a policy error. Based the experience of the last 10 years an unforced error appears very unlikely; across developed markets policy has been systematically loosened at every downward turn in activity. The risk in our view is one of a constrained policy solution where rapidly rising inflation trumps growth concerns. Furthermore, even if econometrically valid, it is unlikely in our view that the Fed would or could sustain such an unpopular policy stance on an inflation model or forecast.
There is at present very little sign (outside the special case of the UK) of inflation which would constrain monetary policy. Energy and other commodity prices have stumbled over the past year for example. In the US, core inflation has fallen to 1.7% year-on-year to June having been as high as 2.3% in January. Last Friday’s below consensus retail sales figures have contributed to a decline in the Atlanta Fed’s GDPNow forecast for Q2 17 GDP to 2.4% from 4% at the start of June, just before the most recent FOMC meeting.
We expect in turn that the US Fed is likely to ease back on the hawkish rhetoric over the summer and if the US data continues to disappoint will flip/flop as it has done on numerous occasions in the past – there is no criticism implied as this is just data dependence.
In this respect the path of least resistance for the Fed would be to continue to prepare the market for balance sheet reduction but to take the prospect of a near-term increase in interest rates off the table. In this way, the slope of the yield curve (and bank profitability) would be maintained even as monetary policy remained looser. Such a policy would also avoid a renewed dash into equities by yield-seeking investors as long term rates would not fall.
This feeds directly into our cautious view on equities where it is the absence of upside rather than fear of the downside which is our primary concern at present. In the scenario we describe above, equity investors would also have to factor in lower earnings expectations . Over the last month 2017 estimates have started to fall in each of the US, Europe ex UK and UK. We continue to believe investors can obtain only modestly lower returns than equities in a variety of other markets where the valuation risks are substantially lower.