For a blogger wannabe like me, the current low volatility environment is a killer.
Every day when I come in, I intend to write a blog telling people what I think. Then I realize I will essentially be telling them the same thing that I have already told them. If I keep at it, the few readers I have left will call it quits.
If you can appreciate my dilemma, you would be in a good position to empathize with U.S. Federal Reserve (Fed) Chair Janet Yellen.
In her heart of hearts, I really believe Janet Yellen wants to walk into one of these appearances where she testifies before Congress or gives one of her speeches and drops the bomb with glee: Inflation is accelerating and therefore the Fed is on a path to do what gives it the most pleasure and something it is very good at – smacking down an economy where the price pressures are getting out of control.
U.S. Economy Shows Few Signs of Inflation
Alas, much like a substantial group of market participants, Yellen will have to wait a while. The global economy in general, and the U.S. economy in particular, aren’t much in the mood for showing signs of inflation. The latest weak readings in the headline and core inflation prove that point in spades.1
For the nth time in her various testimonies and speeches, after having spoken bravely about the transitory nature of the low inflation environment, Yellen has had to back off the assertion that the U.S. economy is at the precipice of a giant uptick in inflation. “Gradual” and “puzzling” were the words that stand out in her testimony before Congress earlier this week. In other words, the Fed has been waiting for Godot, in the form of inflation, to arrive despite the fact that he is nowhere to be found.
All snarkiness aside, the Fed is in a tough situation. The entire dataset of the modern U.S. economy informs the Fed that at the current level of employment, inflation is lurking right around the corner. Fortunately, that has not been the case so far.
At the same time, asset prices are getting to all-time highs. Having been smacked by the equity markets in the dotcom boom and subsequently by the housing boom, and despite the lack of actual inflation, the Fed has committed itself to a self-created third leg of its mandate: We will not let asset prices get out of hand, even if we don’t really know for sure what getting out of hand really is.
The irony is that the challenge is not going to get any easier. While the core Consumer Price Index (CPI)2 is likely to be stable, the headline CPI should actually decelerate due to base effects alone.
The bottom line is that the Fed had tied itself to hawkish rhetoric on the back of the Phillips Curve, or the belief that lower unemployment and tighter labor markets will result in higher inflation. It has not happened and, as a result, the market will continue to reduce their expectations of tighter monetary policy.
Good Global Environment for Risky Assets
Thankfully, the global economy continues to do reasonably well:
- U.S. growth is stable,
- The European economy continues to surprise us with its persistent strength,
- And while China may soften a tad due to tightening of financial conditions, it is unlikely to roll over.
Further, the European Central Bank (ECB), the other large central bank that is getting closer to policy reversal, is playing it like the Fed of old, giving the European economy room to grow and not being in too much of a hurry to tighten policy.
You put it all together – good global growth, interest rates remaining low, lack of inflation, the dollar stable to soft, emerging markets foreign exchange (EM FX) behaving – it is still a good environment for risky assets, as we articulated in our Mid-Year Outlook.
Much like the markets since the 2008 financial crisis, we will continue to climb the wall of worry, this time about potential policy changes that never arrive in size.
We continue to like equities, especially international and EM. The valuation case for both is getting weaker but there is still enough economic momentum and a more modest risk of policy reversal, unlike the U.S., for them to keep coasting.
Credit should continue to provide modest income but the case for further spread tightening is not that great. I believe EM local currency debt and EM FX are the best asset classes in credit.
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