It is William McChesney Martin, U.S. Federal Reserve Chair from 1951-1970, who is credited for the often-used metaphor that central banks are "in the position of the chaperone who ordered the punch bowl removed just when the party was really warming up". The "punch bowl", of course, is accommodative monetary policy — and we believe central banks globally look increasingly set to take on the responsibility of removing it after two years of steady global economic growth acceleration. The Federal Reserve (Fed) just raised policy rates for the third time in the past year — and has hinted that it may be looking to raise rates two (possibly three) more times in 2018. Meanwhile, the European Central Bank and the Bank of Japan are at least beginning to think about where they could pack away their punch bowls after being prominently displayed centerpieces for most of the past decade.
We believe the data suggests, however, that the party-goers may not be that overserved. While economic growth has certainly accelerated, inﬂation measures across all major regions have not. The U.S. is the closest to the widely-used 2% inﬂation target at 1.6% as of 03/30/2018 (using core Personal Consumption Expenditures (PCE) as our inﬂation proxy, the preferred measure of the Fed). Core inﬂation in Europe is lower at 1.0% and core inﬂation in Japan is lower still at 0.5% as of 03/30/2018. Some argue it's just a matter of time before the juice catches up with us; that traditional warning signs of inﬂationary pressures — such as tightening labor markets — are ﬂashing red. However, others are downplaying those traditional metrics. They argue that some of these metrics are as irrelevant today as the punch bowl in the famous quote. They note that the once-strong relationship between unemployment and inﬂation — the so-called Phillips Curve — has shown little correlation over the past 20 years.
As we wait for the inﬂation picture to come into better focus, concerns are growing that the current administration is beginning to take a few sips from the protectionist punch bowl. Antennae ﬁrst perked up at late-January's Global Economic Forum in Davos, Switzerland, where U.S. Commerce Secretary Wilbur Ross stated that the U.S. "was done being a patsy on trade." The topic became headline news when the U.S. announced a set of tariffs — ﬁrst on steel and aluminum and then more- directed tariffs on China in response to what they perceived are unfair business practices. Since then, several countries have been exempted from the steel and aluminum tariffs and negotiations between the U.S. and China are underway, seeking a trade compromise that will have less impact on the global economy. We believe only time will tell.
Our research indicates that with economic growth on solid footing, it is these two uncertainties — monetary and trade policy — that drove the volatile markets in the ﬁrst quarter of 2018. Nearly all asset classes are slightly negative thus far this year (exceptions being emerging market equities and debt as seen in the chart below). If central banks can get it "right" — slowly and appropriately reducing accommodative monetary policy — and trade disagreements can be settled, the economic party may be able to continue throughout 2018. If not, it could be time to look into potential other investment opportunities and safer asset classes.
The Return of Volatility
We believe ﬁrst quarter global equity market returns can be broken down into ﬁve fairly distinct periods. First came the euphoria period (ﬁrst purple bar, 7.3% return) — a carryover from 2017, where we believe investors thought that nothing could go wrong in the global economy or ﬁnancial markets. Then came the inﬂation fears (ﬁrst orange bar, -9.0% return), driven by concerns of an overheating U.S. labor market and a faster-acting Fed. Next came inﬂation reassurance, (second purple bar, 5.7% return) as actual inﬂation data failed to match higher inﬂation fears. Then, just when all seemed calm, tariff tiffs started (second orange bar, -5.3% return) as the Trump administration ratcheted up its protectionist rhetoric. We limped to the end of the quarter with a 1.4% return (third purple bar).
For all the talk of potentially higher consumer prices, we believe there has been very little change in the underlying inﬂation indexes. U.S. year-over-year core inﬂation, as deﬁned by the Personal Consumption Expenditures (PCE) index, was reported at 1.9% in mid-2016 and has been in a range of 1.3% to 1.6% since then until the end of March 2018. January’s 2.9% year-over-year wage growth data point led some investors to believe higher inﬂation was on the way — but that data point was subsequently revised down to 2.8% and, with February’s release, fell to 2.6%. Europe and Japan are having an even harder time generating inﬂation. Europe has not had year-over-year inﬂation higher than 1.2% in the past ﬁve years. Japan has ﬂirted with deﬂation over the past two decades. Recent euro and yen currency strength has not helped either region.
Shifting Monetary Odds
Despite the lack of inflationary pressures, we believe the Fed seems to be on a mission to get back to at least some semblance of historically normal monetary policy. Many professional investors utilize the Forward Rate Curve to determine the probability of a Fed rate hike and about how the market is feeling about the future movements of interest rates. The Forward Rate Curve is calculated extrapolating from the risk-free theoretical spot rate. Coming into the year, the Fed projected it would hike rates three times in 2018. At the same time, the Forward Rate Curve seemed to imply that investors weren’t convinced and, as of December 29, 2017, we believe that there was a 62% chance that the Fed would achieve only two or less rates hikes in 2018. With an actual rate hike in March and continued Fed insistence that more rate hikes are on the way, however, investor expectations as of March 30, 2018, have been forced slightly higher as demonstrated in the above mentioned index, and our opinion is that there is a 70% chance that the Fed raises interest rates at least three more times this year. We believe that beyond 2018, the question is where does the Fed want to be in the long run - which is often referred to as the “neutral rate." Currently, our research suggests that the Fed believes this to be around 3% - which we estimate to be five rate hikes away.
Populism’s Death Greatly Exaggerated
We believe the recent Italian parliamentary elections show that populism is alive and well in Europe. The populist Five Star Movement now represents 36% of the Italian parliament and could play a key role in the next government. Meanwhile, German Chancellor Angela Merkel was forced into another “grand coalition" government that will receive meaningful opposition from the anti-establishment AfD (Alternative for Germany), which now holds an unprecedented 13% of parliament. However, in a sign that anti-establishment does not necessarily mean anti-productive, French President Emmanuel Macron and his En Marche! Party (54% of parliament) continues to make progress on reforming the historically rigid French economy.
Over the full quarter, U.S. interest rates moved higher across the yield curve in nearly parallel fashion. But the start-to-end shift higher masked some fairly significant variation in yield curve steepness. Investors came into the year worried about the potential for an inverted yield curve (when longer-term rates are below short-term rates, generally a harbinger for recession). By mid-February, investors grew concerned that the yield curve was too steep and began to fear it was portending higher inflation. By the end of the quarter, the yield curve had flattened back out — beyond where it started the year in fact. That is, while the 10-year yield was up nearly 0.4%, it rose less than short-term interest rates did.
Both investment grade and high yield credit spreads widened in the first quarter. But the spread widening was mostly technical in nature — a supply/demand imbalance — and not a sign of deteriorating fundamentals. Overall credit demand weakened as corporations sold holdings to prepare for cash repatriation in response to tax policy changes and non-U.S. investment fell as currency hedging costs rose. In a sign that fundamentals remain sound, as seen on the chart on page 3, high yield held up better than investment grade fixed income — down only 0.9% vs. investment grade’s 1.5% decline. Also potentially signaling global economic health, emerging market debt had the best return of all major asset classes — up 4.4% — assisted by the weakening dollar.
As noted in the top section of page 4, we believe global equities went through some fairly distinct phases in the first quarter. But the dispersion between U.S., developed ex-U.S. and emerging market equities was within a fairly tight range and our opinion is that relative performance was fairly constant. Based on the MSCI U.S. Equities IMI, U.S. equities had a strong January before giving all of its gains back in February and ending the quarter down slightly. Developed ex-U.S. equities, as measured by the MSCI World ex-U.S. IMI, mostly tracked U.S. equities, though it began to lag towards the middle of the quarter as we believe investors feared some of Europe’s economic momentum was beginning to slow. Emerging market equities, as measured by the MSCI Emerging Market Equities Index, managed to stay in positive territory for most of the quarter, we believe benefitting from economic stability and overall dollar weakness.
Real assets as shown in the indexes in the chart below underperformed global equities in the first quarter, with negative returns across the board. Natural resources were the best performing real asset, but still recorded a negative 1.6% first quarter return. Oil prices meandered between $60 and $65 per barrel and steel/aluminum tariff announcements did not have a meaningful or lasting impact on the asset class in aggregate. Global real estate (GRE) and listed infrastructure (GLI) lagged from the start as fixed income yields moved higher, hurting these interest-rate sensitive assets. GRE and GLI ended the first quarter with the worst returns of all major asset classes — down 3.4% and 5.5%, respectively.
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