With its September meeting out of the way, it is becoming quite clear that the U.S. Federal Reserve (Fed) is a lot less dependent on near-term data than I assumed.
The Fed announcement following its Sept. 19-20 meeting was much anticipated – the unwinding of the Fed’s balance sheet will begin in October – but not that important at the moment.
The tone of the meeting and press conference afterward was undoubtedly hawkish, while the Fed’s economic projections were adjusted lower. The dots on the most important projection that ought to drive Fed policymakers’ thinking – core inflation – moved lower over the medium term, while the Fed Funds Rate projection remained unchanged from the end of last year. In other words, the primary driver of the Fed’s thinking at the moment is the cyclical uptick in growth represented by the real GDP growth rate and the unemployment rate.
Further, if Fed policymakers needed an excuse to temper their enthusiasm for raising rates, Hurricanes Harvey and Irma could have provided the perfect excuse. Instead, they went out of their way to bat that down. In my view, that means any softening in the data near term will undoubtedly be linked to the weather and will be ignored by the Fed and the markets.
Fed Tightening in December Seems Set
In her press conference, Fed Chair Janet Yellen didn’t say anything of consequence.
The path to a tightening in December is virtually set and, if our conviction with respect to synchronized global growth is something to go by, I have to start assigning a higher probability to the Fed’s previously laid out rate path for three interest rate increases in 2018 as well, even with the very real possibility that Fed leadership may look quite different next year.
If that in itself was not enough, add to it that, unlike healthcare reform, Congress seems to be coalescing around deficit-financed corporate and personal tax cuts. If tax cuts eventually pass, the U.S. economic growth rate is likely a few tenths-of-a-percentage point higher in 2018. That would be on top of a current economic growth rate that is somewhat higher than potential.
That raises the question of whether it is time to reassess the current market regime. Ever since the Trump election-driven market cyclical bump got asset prices up in 1Q17, U.S. markets have been driven by the post-financial crisis investment regime of lower rates and inflation growth. The metric that captured all of it was the dollar, which has been in a downward trend for most of the year.
Why It Is Too Soon for Market Regime Change
So, should we start pricing-out the current regime and start pricing-in the new regime of higher rates and value stocks?
I believe it is still too early. This line of thinking misses the larger point on the evolution of the markets’ thinking.
In my view, while lack of fiscal policy movement from the Trump Administration might have been the impetus for pricing out the reflation trade, the real evolution in thinking, after the rush of the Trump election passed, was that inflation was not going to come back even if growth recovered modestly. So a rebound in the growth expectations due to tax reform or a rebound in rate expectations due to the Fed’s hawkish posture will not change market expectations regarding inflation. As long as inflation expectations remain anchored low, a market regime change is less likely, in my view.
So, yes, the Fed is more hawkish and, yes, Congress may pass tax reform, but it is still a world of decent growth, low rates, low inflation, and no regime change. In my view, equities do well, bonds don’t do badly, and the dollar – the marker of the regime – is still in a down trade.
Bottom line: We still like global equities, especially emerging market (EM) equities, and EM local debt is likely the best trade in credit.
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