Economic growth is slowing and financial market conditions tightened materially in the fourth quarter of last year, not least in the US. As a result, the US Federal Reserve has changed its language materially, emphasising their flexibility, rather than suggesting policy is on “auto-pilot”. Meanwhile, China has already been easing policy, both monetary and fiscal, faced with similar dynamics that have been in play for some time.
The change in Fed language has led to an aggressive curtailing of expectations for US rate rises this year, with some suggesting the Fed might even cut rates. Potentially more relevant, some are asking whether the quantitative tightening (QT) programme is likely to be put on hold, in other words, have we reached peak QT?
The “moralists” argue that central banks should hold their line and are wrong to adjust policy in the face of short term financial market stress, as this will only lead to further capital misallocation. The “pragmatists” argue that a material tightening of financial conditions, if sustained, would feed into the real economy and so the Fed is rightly being pre-emptive in responding to the data and relating this to its mandate.
Our view, and this might sound cynical to some, is that the human beings that make up the Fed would undoubtedly prefer the potential for capital misallocation further down the line, rather than a bear market on their watch, especially if it included systemic threat to the financial system. The QE precedent was set over 10 years ago and it won’t take the same massive shock to the economy and financial system this time to initiate QE again, or at least pause QT.
That said, our preference in the shorter term is to not over interpret the shift in language, preferring to “wait and see” for more data points, including macro, the outlook statements from corporates now in Q4 reporting season, Fed language and financial market conditions generally.
On that last point, financial market conditions are tricky to gauge, can turn on a sixpence and are not always driven by the obvious. Take the aggressive widening in the US high yield corporate bond spread in the fourth quarter, which was a significant contributor to tighter financial conditions. Energy is a major weight in the US high yield index, and the chart below shows how correlated the oil price has been to US corporate bond spreads.
US High Yield Credit Spreads and the Oil Price
Source: Bloomberg, 22/01/2018 to 18/01/2019 for US High Yield Credit Spreads
and 22/01/2018 to 22/01/2019 for Oil Price.
Assuming that the sharply lower oil price was a major driver of wider credit spreads (reflecting heightened concerns over the energy sector’s debt servicing costs), and assuming that the sharply lower oil price had little to do with macro (i.e. weaker demand) and lots to do with supply dynamics (i.e. geopolitics), it soon becomes clear how leftfield factors can blast reasonably argued mechanistic interplays out of the water. Maybe it’s not the time to be too clever.
What does all this mean for financial markets? So far this year, in sharp contrast to Q4 last year, markets have been edging upwards on the back of the more dovish statements from the Fed and enthusiasm around US-China trade. Neither are particularly fundamental, or concrete, but the market has been unequivocally risk-on again.
Further out, if the Fed is saying it’s data-dependent then it’s fair to assume that a deteriorating macro environment or re-tightening of financial conditions would need to pre-empt a more concrete easing in Fed policy. If all of this happened, it is still unclear whether it would be net positive for financial markets, never mind the real economy.
In short, it feels like there are too many “ifs and buts” to build a high conviction portfolio currently. As a result, we have added to equity selectively but retain a lower than usual equity weight and a higher than usual gold weight. In bonds, we have been adding to long duration US Treasuries, as they proved their worth as safe havens in Q4, and Emerging Market (EM) bonds, benefiting as they are from a more stable EM currency environment.
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Past performance is not a guide to future performance.
Forecasts are not reliable indicators of future performance.
Investments in emerging markets are potentially higher risk than those in established markets.
Changes in interest rates will affect the value of, and the interest earned from bonds held by the fund. When interest rates rise, the capital value of the fund is likely to fall and vice versa.
For funds investing globally, currency exchange rate fluctuations may have a positive or negative impact on the value of your investment.
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Source for information: Miton as at 22/01/2019 unless otherwise stated.
The views expressed are those of the fund manager at the time of writing and are subject to change without notice. They are not necessarily the views of Miton and do not constitute investment advice.
Miton has used all reasonable efforts to ensure the accuracy of the information contained in the communication, however some information and statistical data has been obtained from external sources. Whilst Miton believes these sources to be reliable, Miton cannot guarantee the reliability, completeness or accuracy of the content or provide a warrantee.
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