One of the biggest threats to the global economy and financial markets has been the risk of a policy mistake by a central bank somewhere in the world. The good news for investors is that this risk has diminished, now that the Federal Reserve appears to be reorienting its thinking.

We remain in a deflationary environment caused by deleveraging that still has a long way to go. Everyone wants to deleverage but no one really has. Doing so requires coordinated policy action on a global scale. With the appetite for global fiscal stimulus limited, the world’s monetary authorities are bearing the brunt of reflation efforts. So when the U.S. Federal Reserve diverged from coordinated easing, there were consequences—weaker global growth and increased market volatility. If we are to have a period of strong risk asset performance and good economic growth, then the Fed will have to continue to back down from its tightening posture.

Welcome News from the Fed

The Fed’s latest policy communique was welcome news. Slowly but surely, the Fed is doing the right thing for the global economy. Its statement was significantly more dovish than markets were expecting. Not only did it pass on raising rates in March, in its statement and Summary of Economic Projections, the Federal Open Market Committee (FOMC):

  1. Specifically stated that “global economic and financial developments pose risks.”
  2. Passed on providing a balance of risk assessment, despite the strengthening of U.S. data and easing financial conditions.
  3. Alluded to the lowering of inflation expectations as a concern and promised to “monitor inflation expectations closely.”
  4. Reduced the number of potential 2016 rate hikes to two from four in December.

The Fed continues to insist the potential for rate hikes remain “live” at all their meetings, but if it is truly concerned about sluggish global growth and subdued inflation expectations, these structurally driven risks certainly won’t be resolved by June. The Fed’s 5-year forward breakeven inflation rate remains as low as it has been in over a decade and well below the Fed’s perceived 2% comfort zone. There is simply not enough wage or credit growth in the U.S. for inflation to become a significant problem.

This effectively makes it much harder for the Fed to tighten policy. As a result, the probability of a June rate hike is actually quite low, in our view, and thus the threat that such a hike would pose to global growth.

Investment Implications

Global growth is likely to be sufficient to support markets. Valuations of most risk assets are not excessive. The Fed is the wild card. As the probability of future interest rate hikes continue to go down, the outlook for risk assets, including equities and credit, continues to improve. Investors might find the best opportunities in parts of the market that have cheapened relative to the direction of their fundamentals.

  • Corporate Bonds and Loans: Credit quality is only modestly weaker while spreads are still at their highest since 2011 and roughly in line with past recessionary levels (with the exception of 2008). In general, leverage remains manageable and interest coverage for many companies is as high as it has been in years. High yield bonds and senior loans are likely to provide attractive absolute returns. Investment-grade corporate bonds are already rebounding vigorously.
  • Master Limited Partnerships (MLPs): Nowhere is the divergence between asset prices and fundamentals more glaring than in MLPs. Despite little change in domestic energy production, depressed midstream MLP valuations of 8.3 times distributable cash flow—a 27% discount to the long-term average—appear to already discount a huge drop in U.S. production.1 If you have a long view and believe that the United States needs long-term energy transportation infrastructure—with or without fracking—it’s difficult for me to see how current valuations can be justified over the long haul. Already extremely low valuations have drawn deep-value investors.
  • Emerging-market equities: Valuations are as attractive as they have been in a very long time following a prolonged period of underperformance to much of the rest of the world. Macro conditions appear to be stabilizing in much of the emerging world, particularly in the commodity-producing countries, but also in China, where industrial production and the real estate market appear to be recovering from deep slowdowns.

The Long-Term View

My base-case outlook for the long term (i.e., the scenario we believe is most likely to occur) has not changed. Modestly sufficient global growth, benign global inflation, and still-accommodative monetary policy globally will extend the cycle, keep interest rates low for the long term, and favor global equities over bonds and credit over Treasuries.

Conclusion

Contrary to popular belief, the Fed was the root cause of recent volatility—not China, swooning commodity prices, wider credit spreads or a looming U.S. recession. In the wake of the Fed’s newly dovish worldview, the risk of a policy mistake isn’t trivial, but it’s lower than it was a few months ago, setting the stage for better risk-asset performance.

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1 Sources: U.S. Department of Energy and Bloomberg, as of 2/19/16; Alerian, as of 1/31/16; Past performance does not guarantee future results.