For the second time in 2017, the U.S. Federal Reserve raised the federal funds target rate, now at 1.25%. Will the Fed stand pat in September?
The rate hike came amid recent reports showing softer employment growth and lower core inflation. But these might be welcome; headline unemployment is at a 16-year low, so a slowdown could be consistent with the Fed’s goal of full employment, rather than a signal of a peaking cycle. And recent restrained wage growth could signify that a labor shortage is not yet widely seen. The Fed’s current view on slower inflation is that it is transitory; but if inflation weakness persists a more dovish Fed stance might be in the cards.
For now, the FOMC still expects the path of growth and inflation to justify ongoing gradual rate increases; the Fed still appears on track to hike rates another 25 bps later this year, with three or four more hikes in 2018. That would bring the upper range of the target rate to 2.25% -2.50%. However, the market currently expects less tightening than what the Fed is signaling, pricing as if there's about a 11% chance the target rate will reach 2% by the end of 2018.
OUR PORTFOLIO MANAGERS RESPOND AND OFFER AN OUTLOOK BELOW
Brandywine Global - Jack McIntyre, Global Fixed Income Portfolio Manager
We think the Federal Reserve (Fed) has done a solid job of communicating and erring on the side of caution to avoid surprising markets at its Federal Open Market Committee (FOMC) meetings. As widely expected, the FOMC voted to raise the fed funds rate by 25 basis points (bps). However, a lot of new information was issued that markets will need some time to digest. Chair Yellen and the rest of the FOMC laid out the roadmap to start renormalizing its balance sheet. The roadmap itself is a form of forward guidance and the Fed does not have a great track record on forward guidance. Ultimately, the Fed is still data dependent.
We think the level of detail Yellen shared on renormalizing the Fed’s balance sheet and the timing of this information went above and beyond expectations. However, the initial reaction from markets has been somewhat muted. First of all, we did not expect this much information until the FOMC’s September meeting, nor did we anticipate Yellen would commit to unwinding the balance sheet in 2017. Of course, there have been times when Fed policy has not matched up with its previous rhetoric. We think markets will be quick to alert the Fed if it tightens too much or too fast at future meetings. We saw it before with the 2013 Taper Tantrum. If U.S. equities were to sell off in reaction to a Fed policy misstep, that market volatility may itself be a form of tightening of financial conditions.
Behind the move
The Federal Reserve (Fed) raised the federal funds target rate as expected on Wednesday despite unspectacular growth, underwhelming inflation and only modest wage growth. The Fed certainly took all of these factors into account, as well as considering the positive growth in the U.S. and improving growth abroad, along with the ongoing accommodative financial conditions—including low borrowing costs and a recently weaker U.S. dollar. Further moves later this year may become more doubtful if inflation continues to disappoint, and if one or more of the other positive factors begins to falter.
If the Fed does hike again this year, as we expect, we think it’s important to note that this would not necessarily mean tighter liquidity or higher volatility in the bond market. The Fed has now hiked at three consecutive quarterly meetings, yet during this period the U.S. dollar has moved down, bond yields are lower and risk assets are well supported. The small moves by the Fed have been offset by the much larger impacts of somewhat stronger global growth and a positive tone in markets. As long as growth and risk sentiment remain positive, additional Fed hikes may not have that much of an impact on markets.
ClearBridge Investments - Jeffrey Schulze, CFA, Investment Strategist
Fed sticks to plan as growth remains solid
As expected, the Federal Reserve raised its benchmark rate 25 basis points to 1% at the June Federal Open Market Committee meeting. Market participants largely priced in the rate hike and the Fed gladly took the opportunity to continue on its slow-and-steady pace of normalizing monetary policy. Some investors may be confused about the disconnect between the weak first quarter GDP reading of 1.2% and a Fed that continues to hike. One reason why the Fed has discounted last quarter’s weak showing is the persistent seasonality associated with the first quarter. Weaker first quarters have been common since the 1990s but are even more evident in this cycle. According to Jefferies, GDP growth in first quarters since 2009 has averaged 1% compared to a collective average of the remaining quarters being 2.5%. That is a stark difference in growth and it would be unwise for the Fed to put too much faith in a seasonally weak reading.
The Fed also provided additional - and much anticipated - visibility on balance sheet normalization. In its statement following the FOMC meeting, the Fed outlined the timing and magnitude for the reduction of the assets on its $4.5 trillion balance sheet. As expected, the tapering should be gradual in part, at least, to avoid a repeat of the 2013-style “taper tantrum.” Specifically, the Fed stated it intends to “gradually reduce” its holdings of Treasury and agency securities from an initial $6 billion per month to $30 billion per month over the next 12 months. The plan affirmed our belief that the reduction will likely be slow and methodical over the course of several years. In any event, future meetings should give us more details on Fed’s preferred route of reversing post-financial crisis quantitative easing.
US rate rise and Emerging Markets – glass half full or half empty?
As emerging market (EM) investors, with a truly international perspective, we recognise there will be potentially mixed responses to the US Federal Reserve (Fed) rate hike. On the one hand, it can be seen positively: an indicator of renewed confidence in the growth trajectory of the US economy, which is important for many emerging market companies’ prospects. On the other, the key concern of investors is not the immediate rate hike – which was widely flagged and probably ‘in the price’ – rather the frequency and magnitude of subsequent rises. Will the Fed tighten in autumn? And also in December?
Brandywine Global - Jack McIntyre
For now, we believe there are indications the Fed will continue to tighten slowly—U.S. data has been a little suspect as of late. There has also been a lack of inflationary pressure—as noted during the June 14 meeting—as well as growing uncertainty over the future of fiscal stimulus and questions over the future of FOMC leadership after February 2018. Chair Yellen did clarify that she intends to serve out her existing term, but she has not yet had a conversation with President Trump, which to us signals that she likely will not be asked to stay on. Regarding the lack of inflationary pressure, it may just be part of the cycle where we see non-inflationary growth persist, the Treasury curve flatten, and break-evens continue to decline. There could be some secular influences as well—rates move higher and debt-servicing costs increase; capital that would otherwise go to consumption, savings, and/or investment would have to go to higher interest payments.
All eyes have been on U.S. monetary policy, but we do not look at the Fed in isolation. Generally, we think global monetary policy will skew toward accommodative and should not be a risk to synchronized global growth. The leaders of the other two G3 central banks, Haruhiko Kuroda and Mario Draghi, have both suggested that the fat-tail risk of deflation has come to an end. We think it is very interesting that the Fed and European Central Bank both lowered inflation estimates while increasing growth forecasts at their respective June meetings. That leaves us in the “sweet spot” of the cycle, where the global economy is not experiencing deflation or inflation. In our opinion, this environment should create a constructive backdrop for risk assets, particularly emerging markets. Furthermore, we think developed market yields may remain range-bound—these bonds are caught between the ideological battle between bond market bulls and bears. The bears think decent global growth will lift developed yields higher while the bulls think the combination of non-inflationary growth and the uncertain timeline of fiscal stimulus will keep these yields anchored.
Outlook and opportunities
We expect the global economic recovery to continue, aided in part by a still-accommodative policy backdrop. Growth in the US has actually picked up this year, as strength in the factory sector has offset a slowdown in housing. Global growth has similarly been better than expected—specifically, the surprising strength of Chinese growth. While positive, neither the growth nor inflation data suggests an overheating that would cause a material shift in central bank policy. To the contrary, inflation remains low around the world, and that should prevent central banks from shifting their stance too much, even if they do some normalization in the meantime.
The backdrop of continued recovery and supportive policies will be especially beneficial for parts of the market that we believe still have value, such as emerging market bonds and investment-grade credit. Emerging markets were very much out of favor at the end of last year due to fears about protectionism and tighter monetary policy, among other things. Western Asset took the contrarian position that these assets were priced too low, and that better growth would ultimately be a positive development for the asset class. Even as emerging market assets have outperformed year-to-date, yields remain elevated and we believe these assets are uniquely positioned to benefit from continued improvement in global growth. We also have an overweight to credit, including some exposure to European banks—we think the recent capital raises by the European banking sector is good news for bond holders.
ClearBridge Investments - Jeffrey Schulze
Economic growth appears to be on solid footing for the foreseeable future. Labor markets continue to tighten, credit conditions are strong, U.S. Purchasing Managers Index readings continue to show healthy expansion and leading economic indicators are grinding higher. On the corporate front, we are coming off the strongest profit growth in the S&P 500 since 2011 as we distance ourselves from the energy-induced profit recession of 2015. One way to get an early gauge of economic activity is the Atlanta Fed’s GDPNow assessment. Currently, the GDPNow forecast for the second quarter is showing 3.4% growth. This reading relies more on “hard data” or actual economic activity, such as new residential construction and trade in goods and services, and is viewed by many as a more conservative way to get a mid-quarter read on the economy.
Emerging markets: a long-term growth story
Most importantly, investors shouldn’t lose sight of the numerous long-term drivers underpinning emerging markets, which have been overshadowed by recent volatility. Demographic trends provide a young and growing workforce, and debt levels at both a sovereign and household level are low, especially compared with developed market peers. Many emerging market countries are also at an advantage in terms of natural resources and technology benefits.
Adjustments following large-scale changes in monetary policy are rarely smooth; for long-term, fundamental and research-driven stock pickers, any short-term volatility resulting from the rate hike could be seen as a buying opportunity.