The Fed hikes rates into mediocrity
The U.S. Federal Reserve (The Fed) raised interest rates for the fourth time of the expansion at today’s June 14 meeting, taking the U.S. policy rate slightly above 1%. While this decision was widely anticipated1 by markets, there are several important observations for global investors to bear in mind going forward.
The macro backdrop for today’s decision: Domestic mediocrity offset by global strength
The Fed normally hikes interest rates into economic strength. But following a lackluster showing in the first quarter (1.2% real U.S. GDP growth), the U.S. economy in our view is continuing to underperform expectations. For example, the Citi U.S. Economic Surprise Index—a measure that tracks incoming economic data against consensus estimates—collapsed from +58 in mid-March to -40 in early June. This is a dynamic that we correctly anticipated in our Global Market Outlook. But it has yet to push the Fed off course.
Inflationary pressures have also failed to materialize. Core consumer price inflation slowed markedly in March, April, and May. Again, this is normally a dynamic that would slow the Fed down.
The rate hike justification
So, what gives? Regarding the outlook for both growth and inflation, it appears that the Fed is essentially forecasting that much of the recent slowdown is transitory in nature. There are some elements to this argument that we are receptive to. The inventory drawdown in the first quarter was a large headwind to growth in the first quarter (and is likely to reverse) and a price war in the telecom industry has had a significant impact on the recent inflation statistics (and is likely to fade away over time). But we also see more fundamental reasons for caution. Bank lending to consumers AND businesses has cooled notably in recent months. Automobile sales – one of the timeliest indicators on consumption activity – is tracking three percent below its first quarter average through May. And rental price inflation is starting to moderate after a significant build-out in multifamily homes in recent years.
While domestic economic fundamentals, in our view, have been lackluster, three other forces have aligned to warrant today’s hike.
- First, the global cycle has strengthened. The slowdown in China, in particular, was a major source of worry for the Fed in 2016. But more recently we have seen a broad-based reacceleration in economic and earnings trends across the emerging market economies. Stronger global growth removed a source of downside risk to the Fed’s domestic U.S. outlook.
- Second, the unemployment rate at 4.3% is very low by historical standards. Monetary policy acts with a lag in terms of its impact on the real economy. And with the economy by most measures at or near full employment, this was a key catalyst for a hike.
- Third, financial conditions remain very accommodative. Despite having now raised short-term interest rates four times this cycle, the ten-year Treasury yield is actually lower than it was before the Fed started hiking. Longer-term interest rates on mortgages and business loans are what matter for economic activity, and the Fed has not injected much restraint into the economy through its rate hikes thus far.
The balance sheet unwind: Making monetary policy boring again
In addition to hiking interest rates, the Fed is also talking about starting the process of winding down its balance sheet—its portfolio of asset holdings—later this year. In many ways, this is the opposite of the Fed’s Quantitative Easing (QE) program, where they bought assets to suppress long-term interest rates and stimulate the economy. Now that the Fed is closer to achieving their goals, they want to gradually unwind the balance sheet. The key for investors is that they plan to do this in a passive, predictable, and plodding way:
- Passive—Rather than selling their Treasuries and Mortgage-Backed Securities (MBS), the Fed will simply stop reinvesting the principal when these assets mature.
- Predictable— The cessation of reinvestments is expected to be introduced gradually every three months on a pre-specified timeline (rather than turning off the spigot all at once).
- Plodding – Recent simulations from the Fed staff suggest they are planning to draw down the balance sheet at a much slower pace than that at which they grew it following the crisis.
San Francisco Fed President, John Williams, has even said2 that they have designed the process to be “boring.” Markets can handle boring, and as such we do not expect a major impact from this proposal on fixed income assets.
Market implications: Not a favorable mix for U.S. equity investors
The biggest issue for investors, in our view, is that the Fed is hiking into a mediocre U.S. economy. We don’t see the fundamentals as being strong enough to warrant another hike this year. But the risks to this view are skewed towards the Fed staying on course for another rate increase in September or December. Under this scenario, our analysis of Fed hiking cycles over the last 30 years shows that rate hikes can be quite damaging to valuation multiples. In a normal cycle, this headwind is more than offset by a strong economy and strong corporate earnings. But in a mediocre growth world, there is unlikely to be enough fundamental support from U.S. earnings to warrant chasing the U.S. equity rally. Instead, we continue to look for opportunities in non-U.S. equity markets, where valuations are more attractive, and economic and earnings trends are stronger. Emerging market local currency debt is another area where we see good value.