The global economy is now firing on all cylinders, in a synchronized expansion not seen in many years. Corporate fundamentals are strong, and earnings have been steadily growing. Against this economic backdrop, investor confidence has been on the rise. Indeed, on the heels of another year of healthy gains in the equity markets, and surprisingly little volatility, by the outset of 2018, market sentiment was particularly positive. But, with valuations already looking stretched in many areas of the markets, and interest rates poised to go up, one couldn’t help but wonder how long such optimism could be sustained. Then in early February, it happened. A sudden sell-off in the markets took everyone by surprise, as these things generally do, breaking the almost eery calm. Ironically, the catalyst that set-off the dramatic jump in volatility was not a blast of bad news, as one might expect. Rather, it was about too much good news!
This “good” news came in the form of a US government jobs report that showed wages were going up. Clearly confirmation of the ongoing strength of the US economy, rising wages for workers is also an indication of a tightening labour market, and greater inflationary pressure. Because higher levels of inflation could lead to interest rates moving higher, and more quickly than expected, both the bond and equity markets got spooked. The reaction was not limited to financial markets in the US, as the sell-off reverberated across geographies. Equity valuations have since recovered some ground, but bond yields are still rising, as prices have continued to slide. This means financial markets are taking the new inflationary worry seriously.
To better understand this sudden change of dynamic, let’s back-up a bit and remember that interest rates are still at rock bottom levels. At the time of the financial crisis, central banks worldwide invoked emergency measures, such as reducing their benchmark rates to near zero. Later on, a series of bond purchasing programs known as quantitative easing was introduced. The order of the day: fight deflation and bring the world economies back from the brink. Now that economic conditions have improved, these emergency policies are being wound down. The Federal Reserve in the US was the first to begin this process starting in 2013, while most other economies around the globe were still struggling. Under former Fed Chairman Janet Yellen, a gradual approach to the wind down was adopted. This had the double benefit of allowing the rest of the world time to catch up, while maintaining low volatility and risk-taking in the financial markets, both of which were perceived to be key to the ongoing recovery. Now enter President Donald Trump to the equation, and that gradualist approach is facing new challenges.
Normally, governments save fiscal stimulus for periods of dwindling economic growth when joblessness is high. But, not the Trump administration. As Eric Bushell of Signature investments has noted: “Trump is aggressively using all policy levers to accelerate growth, his economic and geopolitical cure-all to Make America Great Again.” [1]Among other initiatives, the administration has launched “a frontal assault on financial regulation” which will make it easier to lend money. Good news for the banks, but deregulation will also act as a new source of stimulus for the economy. The real biggie, however, is Trump’s massive tax reform package recently passed by congress. That will really stoke the fire in an economy that is already operating close to full capacity…
So as the US economy “heats up”, it makes sense that financial markets should be a tad concerned about recent signs of inflationary pressure. If the current rate of inflation were to creep up beyond the target level, the Federal Reserve may have no option but to step up the pace of interest rate hikes. Financial markets have already priced in 3 hikes this year, but now market forecasters are expecting we will see at least four increases in the Federal benchmark rate. It’s still too soon to say which way things will go. Suffice it to say, the new Fed Chief Jerome Powell faces the very significant challenge of striking the right balance, between too much monetary tightening, and not enough.
In this economic environment, central bankers are not the only ones who are now facing a difficult balancing act. As the lead manager of CI Harbour funds, Roger Mortimer explains:
“Historically, bonds have been the “safe” asset class, while equites have added incremental return. Considering that rates may now be rising worldwide as growth recovers, the role of bonds as a source of safety is less straightforward, since typically, bonds lose value as interest rates rise. Equities however have already appreciated considerably and are pricing in some portion of expected future growth. […] But bonds will work during those periods when growth is doubted […] Creating stability [for our conservative clients] is a balancing act.”[2]
To fully grasp the nature of the “balancing act”, we also need to know that stocks too can be negatively affected by rising interest rates, and in different ways. This is particularly true today given the extent to which equity markets have appreciated in value, mostly as a result of the low rate environment of the post-financial crisis era.
Ultimately, as investment advisors and portfolio managers grapple with this new balancing act, diversification and careful regular attention to asset allocation will be more important than ever!
[1]“2018 outlook: our portfolio managers assess a complex market.” Signature Global Asset Management, CI Monthly Review, January 2018.
[2] “2018 outlook: our portfolio managers assess a complex market.” Harbour Advisors, CI Monthly Review, January 2018.
