A critical concern for investors remains the extent to which asset price appreciation depends on easier financial conditions, in the absence of convincing evidence that the fundamental corporate profit backdrop is to reaccelerate. A benign interpretation of the recent divergence between bond yields and equity prices is the narrative that central bank commitments to ultra-loose monetary settings have depressed bond yields and stimulated global growth, but that the pickup in growth will be non-inflationary, constituting high octane fuel for stocks because it is benign for bonds. A less comfortable explanation is the dynamic that global QE spawns: the so-called ‘TINA’ effect that propels private sector capital out of one exceptionally overpriced asset (high quality, negative yielding government bonds), into another, (high yielding stocks and income proxy assets), keeping returns positive in a negative rate, slow growth world, at the expensive of assuming more risk. Commodity prices offer no comfort that a synchronized recovery in global growth is at hand, which has important implications for Fed policy and the US dollar. Precious metals are still outperforming industrials, suggesting that the plunge in interest rates globally, not stronger end demand for inputs to the manufacturing complex, has boosted commodity prices since February.
In this zero rate world, marginal shifts in relative monetary policy impart deflation to the US via a stronger dollar, a macro variable that features prominently in the FOMC’s peripheral vision. The 20% appreciation in the value of the US dollar since mid-2014 has indeed keyed off of relative shifts in policy as proxied by 2-year swap rate differentials. But the Fed has only managed one quarter point rate increase so far in this cycle while maintaining a bloated balance sheet, so interest rate differentials shifted in favor of the dollar almost exclusively due to other global central banks easing policy. In the absence of Europe, Japan, or China’s economic momentum demonstrating enough strength to justify a moderation in the level of monetary accommodation deployed to support those economies, any increase in the expected path of US rates will prompt a resumption of the dollar’s appreciation, even as markets fixate on how shallow this tightening cycle is likely to be relative to history.
The reason that asset and currency markets question the Fed’s need and doubt its ability to increase interest rates is that estimates of the equilibrium real rate of interest, the rate allowing an economy to operate at full employment, have dropped so precipitously, implying that current policy isn’t actually that loose. We have been arguing that the real terminal rate is close to zero.
Even if the end point of the tightening cycle will be lower than it has been, investors shouldn’t extrapolate lower for longer to mean zero forever. The Fed is closer to achieving its mandate of full employment and 2% core inflation, than markets discount. While inflation remains below target, it has clearly bottomed for this cycle. The recent acceleration in domestically-geared core service price inflation is a function of faster wage growth, emblematic of receding labor market slack.
The primary lubricant for EM growth and asset prices in recent months has been easier financial conditions, courtesy of the Fed. Any marginal tightening in financial conditions is a recipe for turbulence in EM assets. More broadly, there isn’t much disagreement about monetary policy’s diminishing marginal ability to sustain asset price appreciation from current valuation levels. Global EPS growth appears to be bottoming and our models point to a break into positive territory by the middle of next year, but with very little cushion for any negative shocks.
We acknowledge investors’ need to generate income; missing out on an incremental melt up in risky assets when ownership of low or negative yielding safe haven assets all but guarantees a real loss of purchasing power makes that bugaboo particularly acute. Central bank asset purchases have exhausted their compression of government bond term premia but continue to push high-grade corporate spreads tighter. While we reluctantly accept that the search for yield requires identifying the least expensive asset to satisfy that mandate, we have a high conviction that the combination of continued economic expansion, attractive valuation, and a shift away from fiscal austerity support a strategic allocation to US TIPS, and inflation protection in other markets as well, for that matter. A rate hike in the near-term will not alter the Fed’s long term cautious approach to policy normalization so TIPS breakeven yields are destined to rebound from today’s depressed levels.