Over short-term horizons, financial markets are driven by stories rather than facts. Over the longer term, however, stories and facts tend to converge because stories that stray too far from fact become untenable. So which stories are underpinning financial markets at the moment? Here are a few:
- Tensions with North Korea, concerns over the impact of the withdrawal of monetary stimulus, weak inflation, and political gridlock in Washington will combine to prevent the Federal Reserve from tightening meaningfully.
- The conflict with North Korea will develop into a “cold war” scenario with little impact on global activity.
- Global growth is strong and, for the first time since the global financial crisis, we are experiencing meaningful growth in the U.S., Europe, and China.
- President Trump is not serious about curtailing trade—all of his tough talk is merely posturing to obtain a favorable negotiation stance.
Taken together, this is a wonderful combination of: (1) uncertainty that is severe enough to preserve monetary accommodation but not severe enough to damage growth, (2) inflation that is low enough to worry policymakers but not deflationary, and (3) growth that is strong enough to lift trade but not strong enough to make policymakers think they are behind the curve. In short: not too hot and not too cold.
Markets may be underpricing rate hikes
To avoid being caught wrong-footed, we continuously question these stories and compare them to reality as we see it. Are there any challenges to the “Goldilocks” scenario described above?
First, growth and interest rates rarely diverge for sustained periods of time—as growth increases, market (and policy) interest rates tend to rise. We anticipate a robust growth recovery and believe that core rate markets are not currently reflecting this reality. Any progress by the Trump administration in pushing through its legislative agenda—which we believe is very possible—could be the catalyst that prompts core interest rates to move in line with global growth.
Moreover, the Fed is likely to be very cautious in its approach to balance sheet tightening to avoid upsetting markets (another “taper tantrum” must be avoided at any cost). If it succeeds in implementing tightening measures without causing any disruption in the markets, the Federal Open Market Committee may be emboldened to further tighten by hiking the policy rate. We do not subscribe to the view that the low-equilibrium real interest rate (r-star) will restrict the Fed from hiking more than a couple of times. The r-star rate is derived from the level of inflation—if inflation picks up, the Fed will adjust the r-star without much fanfare.
Reports of death of Phillips curve may be exaggerated
Will inflation rise? Over the short run, energy price increases will feed through to both headline and core inflation, and we also expect some inflationary impact from the recent depreciation of the U.S. dollar. It is true that the Phillips curve is flatter than in the past (i.e., the traditional correlation between low unemployment and wage inflation has broken down), but this may come down to the changing composition of the labor force as the experienced baby boomer generation is replaced with less experienced (and lower-paid) graduates and to the “Amazonization” of the retail industry. However, declaring the death of the Phillips curve is akin to declaring the death of the basic law of supply and demand. This is a jump we are not quite ready to make.
In addition to the Federal Reserve, a number of developed market central banks are on the path toward more monetary tightening, including the European Central Bank, the Bank of Canada, and the Bank of England. The Bank of Japan appears to be lagging the tightening cycle, but Governor Haruhiko Kuroda implied at the recent Jackson Hole conference that asset purchases may soon be reduced. Overall, we regard the financial market narrative about the very benign outlook for global monetary policy to be somewhat at odds with the reality that most of the central banks in the developed economies have started to take steps toward a tighter monetary policy stance.
North Korea threat to U.S.-China relations
On geopolitics, the most likely endgame on the Korean Peninsula is that North Korea obtains full nuclear capacity and that the United States has no choice but to accept this. However, the process is unlikely to be smooth, and we expect frictions to increase between the U.S. and China. An abrupt increase in tensions between the U.S. and China presents a permutation of the geopolitical game that has consequences that are not priced by the financial markets.
Finally, we subscribe to the “strong global growth” narrative, but we are on the lookout for some moderation and rotation in growth momentum away from the eurozone and China and toward the U.S. Growth in the eurozone has been supported by loose monetary policy and benign oil prices, and both of these tailwinds are set to fade. In China, we anticipate some growth moderation as the tightening of the monetary policy stance that has taken place over the past six months or so is transmitted to the real economy. However, we expect growth to accelerate in the U.S. as fiscal resources are put to work to rebuild the areas that were destroyed by the recent hurricanes.
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