The Outlook: February 2019 economic commentary
Global equity markets have posted some dramatic swings in recent months. Having fallen 13% during the fourth quarter of 2018, the MSCI All-Country World equity index has risen nearly 10% so far this year.
Several factors unnerved investors towards the end of 2018, including a slowdown in the global economy, the ongoing trade skirmish between the US and China, and worries about the Italian budget. However, the single most important factor behind both the market declines in Q4 and the bounce-back so far in 2019 has probably been the actions of the US central bank, the Federal Reserve, or ‘Fed’.
The Fed’s U-turn
For much of 2018, markets were not unduly fazed by the Fed’s programme of gradually unwinding the emergency stimulus measures put in place in the wake of the 2007/8 financial crisis. A robust labour market and the strength of the US economy, fuelled in large part by the Trump tax cuts, enabled the Fed to increase interest rates at a pace of one 25 basis point hike per quarter, while also overseeing a decline in its balance sheet at a pre-defined rate.
However, in early October, Fed chairman Jerome Powell ushered in a bout of market volatility when he indicated that the US economy no longer needed extremely loose monetary policy and that the prevailing level of official interest rates were ‘a long way from neutral’. The neutral level of interest rates is that which neither stimulates nor slows the economy. As a result, markets interpreted Powell’s comments as indicating that the process of hiking rates still had a long way to go.
Although Powell subsequently dialled back his hawkish comments – in November, he described rates as ‘just below’ the Fed’s range of estimates for neutral – the shift at the Fed was not enough to satisfy markets. At its December meeting, the Fed lifted borrowing costs for the fourth time in 2018, and although it revised down its expectation for rate hikes in 2019 from three to two, the markets had been expecting more accommodative guidance given the loss of momentum in the global economy and weakness in equity and credit markets. Moreover, despite hopes that the Fed would signal some flexibility regarding quantitative tightening (QT i.e. the reduction in the Fed’s balance sheet following the post-crisis quantitative easing, QE), Powell indicated that the programme would run on ‘autopilot’.
With markets having fallen sharply in the wake of the Fed’s December meeting, Powell finally relented on 4 January, when he said the Fed was listening to markets and that policymakers would be patient and flexible regarding future policy decisions. The policy shift was confirmed at the Fed’s 29-30 January meeting. Citing recent global economic and financial market developments, along with muted inflation, the Fed’s January statement removed guidance regarding ‘further gradual increases’ in interest rates and emphasised a patient approach to future rate moves. Indeed, the statement was more dovish than observers had expected, suggesting that the process of balance sheet adjustment could be adjusted if conditions warrant.
Why the Fed’s shift matters
The dovish shift at the Fed is important for investors for several reasons. Firstly, it is clear that the deterioration in financial conditions towards the end of 2018 – i.e. the sharp fall in equity markets and a widening in credit spreads – was a key factor behind the change in stance. In effect, the Fed revealed its concern that tighter financial conditions could usher in a sharp slowdown in the economy through the impact on business and consumer confidence, wealth effects and corporate financing costs. On this interpretation, investors can rest assured that the Fed will only let markets fall so far before intervening, either verbally or through policy tools, in an attempt to stop any decline.
The shift also reduces the risk that the Fed will push the US economy into recession by overtightening policy. By putting a floor under markets, the Fed averted a vicious cycle whereby tumbling equity markets usher in weakness in the real economy, which in turn could further undermine equity markets, etc. Moreover, an extended pause in rate hikes will give the Fed a better chance of assessing how its monetary tightening - which often operates with a lag - has impacted on the real economy at a time when the stimulus from the Trump tax cuts is fading.
In addition, there is also the possibility that the change in stance from the Fed reflects a somewhat more relaxed attitude to inflation. If so, this might facilitate stronger economic growth than under a scenario whereby policy was tightened mechanically and pre-emptively in response to the theoretical inflation threat posed by historically low levels of unemployment.
The Fed’s change in attitude towards its balance sheet is also significant. Although the Fed had anticipated that the wind-down of its bond holdings would be ‘like watching paint dry’, investors have not been so relaxed about the effective withdrawal of dollar liquidity. Several observers have highlighted the fact that falls in equity markets during Q4 occurred against the backdrop of the Fed increasing the pace of quantitative tightening to a rate of $50 billion a month.
Concerns over quantitative tightening are understandable. The process of quantitative easing was in part designed to signal easy monetary policy, reduce government bond yields and push investors into more risky assets, thereby inflating their price. The opposite, quantitative tightening, might therefore be expected to have the reverse effect i.e. lifting bond yields and deflating the price of risky assets.
Fed policymakers have played down the role of its balance sheet reduction in driving the Q4 falls in equity markets. Even so, a dialling back of QT would be supportive of risk assets as it would ease investors’ worries about liquidity, and potentially cap upward pressure on bond yields.
Moreover, a more dovish Fed holds out the prospect of a peak in the US dollar, which bodes well for emerging market (EM) economies with large external debt burdens. One reason emerging market assets performed poorly during 2018 was the appreciation of the greenback during much of the year, which increased the cost of servicing dollar-denominated debt. A pause in US rate hikes and a more stable US dollar in 2019 could remove a headwind to the performance of EM assets.
Uncertainty still elevated
The dovish pivot from the Fed has been one factor driving equity markets higher so far in 2019. Going forward, however, it is fair to say that an extended pause in US rate hikes is not a sufficient condition for further gains. Evidence that the slowdown in the global economy is being arrested, a favourable resolution to ongoing trade disputes and an orderly Brexit would all have to be forthcoming if we are to see a more durable rally. In this regard, levels of uncertainty remain historically high. However, after a disappointing 2018, the Fed has laid the groundwork for a more positive year for risk assets.
This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.