Jay Powell has been speaking this week and the Federal Reserve chairman’s semi-annual congressional testimony has been suitably guarded — or in market terms “boring” — on the question of whether monetary policy tightening resumes later this year.
A standard quip in financial markets during tightening cycles is that the Fed keeps going until something breaks. Clearly, things started falling apart for risk assets, starting with emerging markets and then developed world credit and equities last year.
Now the US central bank exudes policy patience and tags a slowing global economy and macroeconomic threats such as trade wars and Brexit as things to watch for in markets.
These factors are important short-term drivers, as seen this week in the case of surging China shares and a UK pound with pep in its step, but the more troubling issue stalking risk appetite remains the subdued nature of global bond yields. As highlighted before, a lacklustre US dollar and slumbering government yields help to buoy risk assets, but only to a degree given the late cycle signs from housing and a pronounced rise in debt for the global financial system.
Now while the bond market does not expect another rate tightening from the Fed and in fact leans towards a cut as the central bank’s next policy shift, that’s not the view of many economists and institutional investors. They still think at least one more rate tightening arrives later in 2019. Hopes are high for an extended cycle of moderate growth that helps to underpin the recent rise in equity valuations and keeps the risk show running.
Helping to guide this debate will be the behaviour of inflation expectations. This topic does animate central bankers and will play an important role for markets in the coming months.
Mr Powell during his remarks this week cast doubt on the link between faster wage growth and higher inflation, and instead suggested that expectations are “the most important driver of actual inflation”.
And today the Fed chairman told Congress:
“We are targeting price inflation, not wage inflation.”
This means, inflation expectations need to stage a breakout from current levels in order to sanction the resumption of Fed tightening and support the US dollar.
Market inflation expectations have bounced from last year’s lows, reflecting a weaker dollar and the recovery in oil prices alongside a very dovish Fed.
But long-term market expectations for US inflation (over the next five and 10 years) still remain shy of the Federal Open Market Committee’s 2 per cent target.
And the central bank’s own measure of five-year expectations starting in five years (the forward start smooths out shorter-term factors such as oil prices) remains below the 2 per cent area that was a floor for much of 2018.
For all the Fed’s major pivot on policy since late December, the recovery in expectations of inflation is modest.
As Ian Lyngen at BMO Capital Markets observes:
“In essence, it took a major dovish trajectory change out of the FOMC to simply stabilise this key factor at a lower than target level.”
This comes as other key Fed officials have signalled concern over inflation undershooting in the future, a persistent theme in the current era of globalisation, poor developed world demographics and rapid technological change.
With the FOMC in the process of revamping its inflation framework, Steve Englander at Standard Chartered notes such plans will also guide the market now:
“These discussions are in the context of future policy responses to cyclical downturns. However, given the cumulative shortfall in this cycle and the expressed concerns that inflation expectations may be falling, it seems likely that investors will see these concerns as informally guiding policy in the current cycle.”
Moderating economic growth and renewed downward pressure on inflation expectations will open the door towards Fed easing, regardless of the FOMC’s updated outlook at next month’s policy meeting. Whether that represents a soft landing or something more serious is a debate looming for investors and markets.
Quick Hits — What’s on the markets radar
MSCI decision on China shares — The rebound in Chinese equities comes as the market prepares for the global index provider MSCI to announce potentially at the end of this week that it will increase the weighting of Chinese stocks in its flagship Emerging Markets index, which is tracked by about $1.9tn of assets globally.
A wall of money pouring into mainland Chinese shares this year has reflected expectations that MSCI will quadruple the A share inclusion factor from 5 per cent to 20 per cent. Should that get the greenlight, MSCI will do so in two rounds, May and August through a 7.5 point rise over both periods. That would result in the weight of domestic shares from China in the MSCI EM index jumping from 0.7 per cent to 2.8 per cent.
This represents just the opening stages of a lengthy inclusion process that over the coming decade will open up China to global investors through indices — which dominate markets these days — such as those from MSCI and FTSE Russell.
Fully weighting China in EM indices would mean a 40 per cent share of the MSCI equity index and about half for the FTSE Russell EM benchmark, according to Société Générale.
The long-term implications are massive and the bank writes:
‘“For emerging equity investors, it creates a dilemma. Beyond the short-term stories — trade dispute, cyclical bottom, flow into domestic equities — the institutional framework matters a lot from a strategic point of view. One of the key issues for long-term equity investors relates to the role of the Communist party within the [Chinese] corporate sector and the economy, with the risk that as the role of the party increases that of the market diminishes.”
US credit on a diet — A key risk for markets has been the fallout from high levels of corporate debt, particularly those with a triple B rating, one layer above high yield or junk. A credit hangover still looms given the scale of debt issuance in the past decade, but there are signs some companies, including Verizon, Kraft Heinz and General Electric, getting to grips with their debt binge. Joining the push is Macy’s, with the retailer noting on its earnings call this week that it is focused on reducing debt from excess cash as the preservation of an investment grade rating is important.
Going on a diet is good news for bondholders, less so for equity investors, notably Kraft, Macy’s and Verizon as the pendulum shows signs of swinging back for the triple B club.