Subdued core inflation allows central banks a very long leash to keep interest rates low. Further interest rate hikes are likely off the table until growth picks up enough to push inflation rates higher.
“Less is only more where more is no good.”
— Frank Lloyd Wright
- The most underappreciated economic theme continues to be the extraordinarily subdued inflation rates around the globe.
- Fed officials are making it clear that conditions must change substantially before they will commence further rate increases.
- Considering the recent downshift in global growth, both the US and China have strong incentives to reach a bargain on trade.
- The challenges that hit EM last year have led to EM local debt being priced at an 18-year low.
- We believe the severe underperformance of spread sectors to global sovereign bonds last year presents a very meaningful opportunity.
Global Low Inflation
In today’s debt-laden subpar expansion, monetary policy endeavors to stay accommodative until growth resurges and presents an opportunity to restart normalization. Then very modest incremental changes can be enacted, with constant vigilance to stop should growth stall. In the US, the window of opportunity to raise rates looked wide open with the economy accelerating to over 3.5% growth (annualized) in the middle two quarters of the year.
Inching the fed funds rate up three times seemed non-controversial. But by December 2018, the US economy was downshifting quickly and the global picture was also weakening. In this environment, a Fed pause was called for. Having guided the markets so clearly to expect a December hike, the Fed followed through, but then executed a pause to a “wait-and-see” approach. The Fed clearly expected that the fed funds rate level would be at the very low end of “the normal range.”
It is not absolutely clear cut, though, that today’s rate is at the bottom of that range. In addition to below-target inflation, growth in 4Q18 may come in close to 1% and 1Q19 is off to a slow start. Maybe, as we expect, this lull in growth is temporary. It is also possible that the fed funds rate is already sufficient.
The primacy of the objective of extending the expansion means that a high degree of certainty must be attained before tightening can re-commence. Some Fed members seem confident that such conditions may come back into evidence. But the leadership of the Fed, what might be lightly dubbed the “holy trinity”—The Fed Chair, Vice Chair and NY Fed president—are all on message. They are dutifully nudging market participants to understand that conditions must change substantially. John Williams, President of the New York Fed, made this point explicitly this week: “…but it would be a different outlook either for growth or inflation” to return to hiking rates. This echoes Fed Chair Jerome Powell’s comments at his January press conference: “…I would want to see a need for further rate increases….” The economy will have to pick up speed for an extended period, bringing inflation with it, before the Fed will tighten again.
Globally, monetary policymakers have been in a more accommodative mode than the US has been in for quite some time as growth and inflation remain below target levels. Indeed, the fear here is that growth will continue to weaken. It was the global weakness, in conjunction with fears of sustained US monetary policy tightening and a potential trade war, that caused risk assets to perform so badly last year.
The question then becomes, “can growth remain sturdy?” European growth is off to a very slow start after last year’s downshift to trend from above-trend growth in 2017. Chinese growth continues to be soggy. Japanese growth downshifted, and non-China emerging markets (EM) are trying to shake off the negative effects of last year’s brutal combination of both downwardly revised global growth and higher US interest rates. Clearly the need to monitor further downside challenges is acute. However, some of the factors that drove last year’s extreme pessimism are fading.
China has cut interest rates and reserve requirements. It has cut individual tax rates and moved to increased fiscal stimulus. Most tellingly, China has very publicly trumpeted the need to reinvigorate the private sector, virtually reversing last year’s program of squeezing private sector borrowers. These policy measures will take hold with a lag, and therefore economic indicators may not turn decisively up for some time. But a long rounding bottom is our base case for China, with growth in the second half of 2019 being better than in the first.
In conjunction with the better economic outlook, the prospects for a dampening of the trade tensions that were so disruptive to global growth seem to be in store. The politics of slamming China publicly played well as long as there was little actual or perceived cost. But with the downshifting of growth, both the US and China have strong incentives to reach a bargain, and have been signaling the likelihood of such an outcome. We do not expect such a deal to come remotely close to resolving all the issues, and expect the economic competition to be a central theme going forward. But we do expect the attenuation of investment projects as uncertainty mounted late last year will subside.
Exhibit 1: J.P. Morgan GBI-EM Global Div Price Index
Where to Look for Value
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