One of the more surprising happenings in a third quarter full of surprising happenings is the resilience of the September FOMC meeting as a candidate for Fed lift-off. Amidst market volatility, global equities have sold off by over 7% quarter-to-date – led by emerging markets (EM) at -19%, followed by Japan, Europe and the US at -12%, -6% and -5%, respectively. Still, the odds are small but non-trivial that a Fed rate hike on September 17 will actually happen. Futures are pricing the probability of this occurrence at roughly 20%.
What will the FOMC do? What should it do? And what are the implications for multi asset portfolios? We maintain our view that a September lift-off is possible, preferable – and not improbable. We expect to see near-term manifestations of this policy shift – and the very high likelihood of a rate hike later in 2015, if not September – at the short end of the yield curve, in the dollar and across global equity markets.
The most immediate effect of a rate hike on markets will be to disprove the naysayers who are betting on a 2016 lift-off, or beyond, generating a small leg up at the two year point of the yield curve and an incremental boost to the dollar. Markets have already been flirting with this idea, as evidenced by the tremendous rally in the dollar since late 2014 and the two-year US Treasury note at recovery highs above 70 basis points (bps). The knee-jerk reaction of developed market (DM) equities will be negative, but given the fairly solid growth picture in the US and developed markets more generally, our tactical view on DM equities remains positive. In any event, DM equities are likely to outperform EM equities as interest rate normalization unfolds.
The US economy is on a solid footing
Our view that a rate hike is imminent this year is first informed by the state of the US economy. Notwithstanding two very weak first quarters and the remaining vestiges of the financial crisis aftermath – notably tight credit conditions, sluggish aggregate business investment, flagging productivity and a housing market that has moved incrementally – US GDP has managed to generate an above-trend average growth rate of 2.6% over the past two years. At present, bright spots abound. The labour market has been tightening at a rapid clip, with the unemployment rate of 5.1% now equal to the FOMC’s own median estimate of the ”natural rate.” The number of job openings in July printed at a record high of 3.9% of total US employment, indicating strong demand for labour. All of this good news for household income reinforces a wide range of supportive indicators for consumption spending. The mighty US consumer is hitting her stride, as evidenced by blowout auto sales in July and August, as well as increases in revolving credit usage. Other measures of domestic demand, such as services
Purchasing Managers Indexes (PMIs) and housing market indicators have been broadly positive. All in all, we view the trajectory of the US economy, and the labour market in particular, as being broadly consistent with the FOMC’s preconditions for a lift-off of the policy rate. Above-trend growth has been whittling away slack in the economy, which should inspire confidence that inflationary pressures are slowly building.