Taking stock: Addressing key questions from institutional investors

As I travel the world to talk about global markets, I encounter questions about interest rates, inflation, trade wars and much more. Below, I answer some of the most common questions I’m hearing from institutional investors.

1. What is the likely path for rate hikes over the next several years?

After each meeting of the Federal Open Market Committee (FOMC), market-watchers search its official statement for any language that’s been added or removed. In June, the FOMC removed two key passages:

•  It deleted its previous expectation that the “federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.”
• It also removed its expectation that the economy would grow at a pace that warrants only “gradual” rate increases.This change in sentiment was illustrated in the Federal Reserve’s (the Fed’s) reviseddot plot:
• The Fed now indicates a median of four prescribed rate hikes in 2018. This means the federal funds rate could end 2018 at the 225-250 basis point (bps) range, from its current range of 175-200 bps.
• For 2019, the median policy prescription indicates an additional three rate hikes, which means the federal funds rate could end the year at the 300-325 bps range.
• For 2020, however, there is only one rate hike in the median policy rescription, which means the year could end with a federal funds rate in the 25‑350 bps range.

The longer-term median policy prescription is for a lower federal funds rate, between 275 and 300 bps. I believe this level likely represents the neutral rate — the level of the federal funds rate that neither accelerates nor decelerates the economy. This would be a much lower neutral rate than we’ve seen in the past, given that productivity has declined significantly over the last decade.

To put this all in perspective: At the start of 2007, the federal funds rate was more than 5%. So while the FOMC’s projection is for rates to increase from here (possibly to a level of 3.5% by the end of 2020), they would remain relatively low by historical standards. I like to think of it as the Fed partially normalizing monetary policy.

Given all of this, what will the Fed do next? Given the FOMC’s stated concerns about the potential for an inverted yield curve, I believe the Fed may consider accelerating balance sheet normalization in lieu of rate hikes if the yield curve gets flatter. However, that would be a difficult decision since the Fed is already creating some emerging markets turmoil with its balance sheet normalization and debt issuance.

2. What is the outlook for credit spreads?

Credit spreads widen when US Treasuries are favored over corporate bonds, which typically occurs when economic conditions are expected to deteriorate or when there is significant uncertainty. (When the economy decelerates, corporate bonds are perceived as riskier and, as a result, the interest rate on them rises as investors demand a higher premium to remain invested in this asset class. In addition, the interest rate on Treasury bonds tends to fall as investors flee to safety, which further causes credit spreads to widen.)

I expect credit spreads to continue to fluctuate in the next several months given the various macro forces at play. I expect the US economy to re-accelerate in the near term, which should help to lower spreads, but risks such as protectionism are increasing, which should cause spreads to widen. I expect that, by year end, credit spreads will have widened modestly as investors become more concerned about many companies’ ability to service the significant leverage on their balance sheets.

3. What will the shape of the yield curve be going forward?

A yield curve merely depicts the difference in yield between bonds of different maturities. The front end of the curve is tethered to the federal funds rate and expectations about future hikes. The long end of the curve is generally believed to reflect expectations about future interest rates. Built into that is a premium for holding longer-term bonds (called the liquidity preference theory) that reflects expectations for global economic growth and inflation. When investors look at the yield curve, they typically focus on the spread between the 10-year Treasury yield and the federal funds rate, and/or the difference between yields for the 10-year and 2-year Treasuries — and both of these yield spreads have narrowed recently. But understanding the dynamics of the 10-year US Treasury — the most popular debt instrument in the world — is more complicated.

The reality is that the yield on the 10-year is impacted by a variety of factors, including:

•  The outlook for global economic growth and inflation.
• The amount of debt issuance (which is impacted by both balance sheet normalization and deficit spending). The “fear trade” (in which investors reallocate to Treasuries from risk assets in times of stress/fear).
• The “yield trade” (in which global investors leave other sovereign debt instruments — such as the German 10-year bund — for the higher yields offered by the 10-year US Treasury).

In the coming year, I expect the 10-year Treasury yield to fluctuate within a relatively wide band (2.75%-3.25%), as different forces exert both downward and upward pressure. Debt issuance and balance sheet normalization should increase supply for Treasuries, sending yields higher. However, the yield trade should increase demand given the significant spread between Treasuries and other sovereign debt, which should help drive down the 10-year yield. And the fear trade threatens to amplify short-term volatility as environments shift from “risk on” to “risk off” and back again. I expect the yield curve to continue flattening given federal funds rate expectations and the band I expect the 10-year yield to move in. The level at which the curve inverts will likely be between 3% and 3.25%, in my view, as that should be the level at which all yields converge. I expect this to happen by the end of 2019 if not sooner. That is not cause for immediate alarm because there is typically about an 18-month lag between when a yield curve inverts and when a recession begins. And it’s important to note that not all yield curve inversions result in a recession.

4. What is our base case outlook for inflation, as well as the left-tail and right-tail risks?

In his June 2018 FOMC meeting press conference, Fed Chair Jerome Powell described inflation data as “encouraging,” but added that he didn’t want to “declare victory.” However, with US unemployment at such a low level and with a very strict immigration policy, I don’t see how wage growth does not increase from here. In addition, given the potential for tariffs to increase, I expect greater inflation when it comes to input costs. In short, I expect inflation data to rise, albeit modestly, with core consumer product index (CPI) inflation remaining above 2% for the rest of the year. (However, given the Fed’s stated tolerance for overshooting its inflation target, I don’t expect the Fed to get more hawkish at this juncture.)

5. What is going on geopolitically (including in terms of trade) and what are the implications for the economy and markets?

The US has taken a decidedly protectionist stance in the last year, walking away from the Trans-Pacific Partnership (TPP), threatening to walk away from the North American Free Trade Agreement (NAFTA) and announcing tariffs on China as well as Canada, Mexico and the European Union (EU). In my view, these are very negative developments that have implications for the global economy for several different reasons:

It may result in more protectionist actions. Tariffs are like bacteria in a petri dish — they multiply quickly. We’ve seen this occur many times throughout history, although perhaps most vividly in the 1920s and 1930s. During this period, US acts of protection were met with rapid responses from Canada and Europe; the trade war escalated rapidly, resulting in tariffs on more than 20,000 imported goods.

Tariffs are often passed down as an input cost, ultimately hurting the consumer. In the April Federal Reserve Beige Book, we saw concern over tariffs (they were mentioned 36 times), with business leaders expressing concerns that input costs are going up. And historically, input costs have risen following the imposition of tariffs and quotas.

This is creating economic policy uncertainty — which has historically dampened business investment. In a recent European Central Bank (ECB) meeting, ECB President Mario Draghi explained that protectionism as well as threats of protectionist actions can “have a profound and rapid effect on business, on exporters’ confidence…and confidence can in turn affect growth.” In fact, the slowdown in US business equipment investment in the first quarter appears to have carried over into the second quarter, with little evidence that the recent corporate tax cuts have provided a significant boost to capital spending. I attribute that to economic policy uncertainty — caused largely by US trade policies/threats.

Protectionism stands in the way of progress. Protectionism doesn’t create jobs — it destroys them by making the economy inefficient. Shielding the US steel industry may save a few steelworkers’ jobs, but I expect a ripple effect that increases input costs, hurts the economy and results in job losses. Some compelling statistics can be found from the protectionist environment of the 1920s and 1930s: US imports from Europe declined from $1.3 billion in 1929 to $390 million in 1932, while US exports to Europe fell from $2.3 billion in 1929 to $784 million in 1932. And from 1929 to 1934, world trade declined by approximately 66%.

These tariffs confuse what should be the US’ most important trade issue — intellectual property violations. Rather than pursue that most egregious issue, the US has alienated those countries that it should be working with to resolve intellectual property infringement on the part of China. That — not trade deficits — should be the critical issue the US pursues, in my view, as it has the greatest potential impact on future competitiveness.

It may impact foreign policy. By imposing tariffs on close allies with the rationale of alleviating national security concerns, the US runs the risk of alienating those allies. This may prove problematic when foreign policy/security issues arise and the US needs help.

Tariffs are not the only form of retaliation. There is a far more dangerous weapon that some of the US’ trading partners possess. Retaliation could come in the form of countries declining to buy US Treasuries, or selling US Treasuries they currently hold — both actions would drive up borrowing costs for the US and have market repercussions. For all of these reasons, the ongoing tariff threats and actions are of very significant concern.

6. What are the implications of the desynchronization of global growth? 

The global growth environment was never fully synchronized. Yes, most economies were expanding in 2017 and still are expanding — but the reality is that this is a simplistic assessment that doesn’t capture the nuances of different growth rates and different lengths of economic expansion.

Each country’s economic expansion is somewhat unique, with different drivers including varying levels of central bank accommodation. The US economic expansion recently reached 107 months in length, while the eurozone expansion is less than 60 months in length. Growth rates are also dramatically different, with India experiencing a high rate of growth (7.4% expected GDP growth in 2018) while the UK is at a relatively low growth rate (1.6% expected GDP growth in 2018).

In my view, a further desynchronization is not a threat in and of itself as different economies will decelerate and accelerate depending on their particular drivers; the problem is when many economies decelerate together because of a common driver, such as a significant increase in tariffs or a tightening of global financial conditions.

7. What are the areas of opportunity in an increasingly volatile market?

It is difficult to have strong convictions in this market environment: My strongest conviction is that security selection will become increasingly important.

• In terms of asset allocation, I believe that broad diversification with adequate exposure to alternatives (such as real estate and market neutral strategies) makes sense.

•  Within equities, I believe technology looks attractive from both a revenue and earnings growth perspective while energy is very attractive from a valuation perspective.
• Small-cap and mid-cap stocks are likely to outperform large-caps, in my view, given the vulnerability created by protectionist threats and actions.
• Finally, I believe that the varied state of global economic expansion makes a strong case for the importance of global diversification for investors. Spreading exposure among a variety of different economies with different growth rates and in different places in the economic cycle may help investors guard against downside risks.