Big Gun – Weekly Navigator

There are few perennial rules in finance, but “don’t fight the Fed” is one that should be adhered to. Firstly because of the size of the US economy and therefore the weight of US assets in global fixed income and equity indices. And secondly because the US dollar is the reference currency for international capital markets. As a result, the Fed has historically had a massive impact on asset returns, market sentiment and the global economy. So, when the Fed talks, it’s critical to listen and to adapt one’s portfolio accordingly.

What is the Fed saying?
Based on data from the September Fed meeting, the median forecast for the federal funds target rate is 3.12% for the end of next year and 3.37% for the end of 2020. The rate currently stands at 2.25% and, along with market consensus, we expect a hike in December. This would imply three new hikes in 2019 and at least one more in 2020. If this plays out, the Fed will have increased their target rate by 312 bps since 2015. This would be in line with previous tightening cycles: going back to 1986, the Fed has, on average, raised rates by 322 bps. The key difference is duration: while the historical average for a tightening cycle is 27 months, the current cycle will hit at least 66 months if our projections are correct, confirming the gradual path of normalisation.

Does the macro picture validate the Fed message?
The Fed operates under the dual mandate of promoting maximum employment and stable prices. To understand their thinking on the former, one should closely monitor the output gap and broader cyclical context. For the latter, look at inflationary pressures. Following the Great Financial Crisis, the Fed looked to restore confidence and financial stability by using traditional monetary policy tools such as interest rates and foreign exchange. But it also implemented unconventional policies, such as portfolio balancing, signaling and liquidity, to firstly support investor sentiment and improve their balance sheets, and secondly to fight the risks of deflation. With these two problems solved, the Fed shifted to more conventional measures, focused on narrowing the output gap, supporting the economy through accommodative policy and allowing the unemployment rate to decline. With these goals also ticked off, the focus shifted toward preventing an inflation surprise due to
either above-potential US growth or too much liquidity from years of very accommodative global monetary policy. This is where we find ourselves today. The fight against inflation is now the key aim of the Fed, which the macro picture validates:
► Due to very low unemployment rates, wage growth looks to be increasing sharply, confirming that the Philips curve works. For instance, latest US data shows a 3.1% year-on-year growth of wages, putting it back to pre-crisis levels;
► Rising input prices, such as commodities, are flowing through the economy, pushing up the ISM Manufacturing price index;
► New tariffs on US imports are increasing the risk of imported inflation.
As shown by our US and Global Inflation Nowcasters, the possibility of
an inflation surprise is high and remains the key risk for multi asset portfolios in the coming months. Therefore, we think that the Fed will deliver and short-term US rates will break 3% next year.

What does the market believe?
The equity drawdowns seen this February and October started with rising rates that were adjusting to both Fed communication and normalisation signals sent by other central banks. Each time, market participants underestimated inflationary pressures and the aim of central banks to reduce liquidity. Based on the Fed Funds forward curve, the market is pricing in two hikes for 2019 and nothing in 2020, which is below Fed projections. In our opinion, this misalignment is a major risk.
Contrary to market expectations, we do not see any risk of recession in the short term that could justify a pause in the Fed’s tightening. We also do not see the current market correction modifying the Fed’s view given stellar equity and credit returns since 2008. Furthermore, US growth and inflation are currently running above the Fed forecast. Therefore, given current economic conditions and fiscal policy, monetary policy is not yet restrictive. For example, at 0.4%, the real one-year rate is below the 1% level that has historically been critical for tipping policy toward restrictive. All this supports our view that the Fed will deliver and the market will then have to adjust its pricing to the downside.

Will history repeat itself?
Historically, market adjustments to central bank guidance have been a key source of rising volatility and corrections, at least in the short term.
The Taper Tantrum is a well-known example, but we can also reference 1994. But how much is 2018 like 1994? For 1994 as a whole, the target rate rose from 3.0% to 5.5%. US stocks were higher, but only thanks to dividends. The S&P 500 index declined by 1.5%, but dividends brought the total return to 1.3%. Just as now, 1994 started with a very low VIX reading of just 11.7. It closed March at 20.5. However, the major difference is the age of the economic cycle. In 1994, the Fed had been aggressive at the beginning of the expansion. This time, the economic cycle is ageing after roughly nine years of GDP growth. Therefore, the risk of policy mistakes seems higher today than in the 1994-1997 cycle. To be clear, we are not saying that expected returns for growth-oriented assets will be negative over the coming years. Indeed, the 1994-1997 tightening cycle illustrates that equities can have a great run before the turn, with US stocks more than doubling from 1995 to 1997. However, in
1994, global equity markets delivered poor returns because of divergences between monetary policy expectations and Fed action. In our view, we are in a similar position today because current market pricing about the Fed normalisation path is too low. Historically, correlation shocks are more likely in times of normalisation. We do not think 2019-2021 will resemble 1995-1997. The key driver behind equity market performance during 1995-1997 was that long-term interest rates fell from 7.9% in November 1994 to 5.7% in December 1997. That is a discount rate tail wind that we do not expect to see this time around.

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