Originally published by Cuffelinks
We are at a break-off point when it comes to the outlook for US monetary policy because three macroeconomic realities clash that could lead to a sudden tightening by the Federal Reserve in the next 12 to 18 months. The risks for investors are skewed downwards.
The first macroreality of 1945 is that the prices of assets around the world are high. Capital prices are not on bubble levels but they are expensive. Global equities and investment-grade and non-investment-grade bonds are the most expensive or nearly the most expensive in 20 years. This opinion should not surprise anyone.
second is that the most important central banks in the world reduce the support they have provided to the markets since 2008. Even if we go back to just 12 months, the Bank of Japan and the European Central Bank conducted asset purchases of US $ 1.5 trillion a year, keeping long-term interest rates low. Today, the European Central Bank is reversing its quantitative easing while the Federal Reserve is introducing quantitative easing. From October 2018 the Federal Reserve will lower its balance sheet by US $ 50 billion per month or US $ 600 billion per year. In January 2018, the European Central Bank cut its monthly asset purchases from EUR 60 billion to EUR 30 billion and plans to stop purchases at the end of the year. We will be in a world of no net central bank support for markets. That is a different environment compared to what markets have enjoyed over the past decade. We expect bond yields to rise even higher.
The third important fact is that the US is introducing fiscal stimuli into a growing economy with full employment. The US budget deficit is rising mainly because of the tax cuts that President Trump initiated and which Congress approved last December. The US budget deficit is now around 4% of GDP and is expected to rise to around 4.25% of GDP in 2019 and 2020.
Fiscal stimulus despite full employment
The graph below shows that the federal budget of the US in the past 50 years usually only had a deficit when unemployment rose. For the first time since 1970, the US budget deficit increases as unemployment falls. Unemployment in the US dropped to 3.7% in September 2018, the lowest level since 1969. Other broader measures for US unemployment are declining, even if they do not approach the 49-year lows. All the evidence points to a humming American economy, but policymakers inject tax incentives.
US tax incentive arrives when the economy reaches full employment
(US budget deficit% of GDP (LHS) and US unemployment rate% (RHS) since 1970)
Source: Congressional Budget Office, Bureau of Labor Statistics
What does the intersection of these three realities mean for monetary policy?
Two main scenarios could play
We call it the first the Goldilocks scenario. This outcome describes the largely benign situation in which no substantial increase in US inflation will occur in the next 12 months. It assumes that the average growth of weekly wages does not exceed that annual rate of just below 3% that it absorbs today.
But since 1950 there have been only four periods in which US unemployment has dropped below 4% and the first three have led to higher inflation. We have never seen a period of several years in which the unemployment rate remained below 4% and inflation remained at 2% or lower. Yet this is what the Federal Reserve predicts for the US economy in the next two years. Under this Goldilocks scenario, the Federal Reserve has indicated that it will increase the US spot rate to 3-3.25% by the end of 2019. If inflation remains low and the Federal Reserve should make such a gradual increase in the US spot rate, we expect the yield on 10-year US government bonds to rise from around 3.2% to around 4%.
If these events were to happen, it would be easy to predict what could happen to global markets. Reasonably higher interest rates would be a small headwind for economies and equities. The US dollar is likely to rise. Investors would probably want to stay away from emerging markets and profitable stocks. But we do not see a major disruption for markets. Prolonged troops press downward pressure on inflation and wages and the Goldilocks scenario could play well, something that market prices tell us that investors expect to happen. But this is a gamble against history.
We have no name for the second scenario. It is when inflation comes up after the average weekly wage growth accelerates the rate of 3% per year. If Trump's tax cuts reduce the economy and the labor market, we expect a meaningful wage growth to take place in the US. There are already indications that companies have difficulty managing labor costs, so that this outcome is possible
What would this mean for US monetary policy? It would mean that the Federal Reserve is wrong to mark another four quarter-point increments of the US spot rate in the next twelve months. If inflation were to accelerate above the 2% target of the Federal Reserve, we would expect the central bank to act forcefully to counter inflationary pressures – President Jerome Powell said that would happen. Under the non-goldilocks scenario, the US spot rate could range between 4% and 4.25% and the yield on 10-year government bonds could rise above 5%. This can also happen quickly. By the second month that average weekly earnings in the US would increase by more than 3% annually, a major reassessment of the tightening of US monetary policy could occur. If this were to happen, a 20% to 30% drop in global equities could be foreseen.
The chances of these market influences
We set the probabilities of scenario two at about 50%, the same probability that we put in the Goldilocks scenario. In other words, we do not know which of these two scenarios is more likely, but we are not talking about a 5% probability of market fluctuations.
Because of these increased risks, we have maintained a defensive stance this year in the Global Equity portfolio. We hold approximately 18% cash, which should strengthen the defensive characteristics of our portfolio and serve as a partial hedge against a potential market correction and higher interest rates in general.
Hamish Douglass is co-founder, chairman and Chief Investment Officer of Magellan Asset Management, a sponsor of Cuffelinks. This article is only intended as general information and does not take into account the circumstances of an investor.
