The Fed’s hawkish stance
For those who thought Janet Yellen a dyed-in-the-wool dove, her Jackson Hole speech on Friday gave pause as she endorsed fellow policymakers’ recent statements that the US economy was strong enough to warrant interest rate rises. Markets quickly adjusted, with the chance of a hike in September leaping from 32% to 42%, up from 22% a week ago. Ten year treasury yields jumped as much as 9bp, while the DXY dollar index rose 0.8%. We think the market has correctly reset its expectations about the US economic outlook and likely Federal Reserve responses. The implication for global asset markets is not altogether encouraging.
The current US economic situation satisfies the Fed’s dual policy mandate. The labour market is reaching full employment as judged by rising wage pressure, high levels of job openings and gradually slowing employment growth. The Fed seems likely to achieve its 2% consumer price inflation target in the coming few months as the year-on-year drag from collapsed oil prices fully wears off and prices are pressured higher by robust domestic demand as signalled by solid revolving consumer credit growth and sharply rising residential rents.
What this indubitably means is that a reliable global central bank “put” is no longer in place. The problem is that a “lower forever” assumption by investors drove the yieldchasing rally seen since the shock Brexit vote in late June. This rally was odd as prices of risk-on assets (equities) rallied in unison with risk-off assets (bonds, gold, and Japanese yen), while most investors left themselves short-volatility. Such complacent positioning inevitably leaves the market vulnerable to inflationary signals or statements of policy intent such as Yellen offered on Friday.
The good news is that the US does not face an imminent recession risk.
1) Inflationary pressure maybe on the up, but it is not sufficient to make the Fed actively fight price rises. Despite recent hawkish talk from policymakers, a slow and steady rate hike path remains most likely.
2) The current real cost of capital is still significantly below our return on invested capital measure. This means that US corporations can still make profitable investments during the initial phase of rate hikes, which limits the chances of a widespread recession.
3) While US corporate profits (as recorded in the national accounts) for 2Q16 fell -2.4% on a sequential basis, the outlook has slightly improved as the drag from the oil and gas sector should lessen due to a stabilisation of hydrocarbon prices. To be sure, a roaring profits recovery is unlikely due to sluggish economic growth, rising wages, a lingering inventory overhang issue and the strong US dollar. At best, the US corporate return on invested capital should remain stable at 5.4% (see chart).
Bringing things together, US economic growth and profits are unlikely to crater, however the economy is transitioning to a phase when real interest rates are more likely to rise than to fall. As a result, volatility seems set to increase. Alas, very high levels of cross-asset class correlation mean there are no obvious sanctuaries where positive absolute returns are likely to be earned. Looking ahead, we would advise investors to shorten duration of fixed income positions and generally lighten up on risky assets.