The July FOMC meeting came and went with no action. This was of no surprise to investment markets, which didn’t expect anything. Since there were no updated projections and no planned press conference, it implied the meeting was not going to be an ‘important’ one requiring additional clarification and Q&A with the press.
The Fed’s statement acknowledged a strengthening of conditions in the labor markets and moderate economic expansion, including a frequent comment on stronger household spending but continued softness in business capex. Importantly, the FOMC noted that near-term risks to the economic outlook have diminished, although global conditions continue to be under review. Overall, the message was a bit more optimistic than some recent statements. As has occurred in a few prior meetings over the past year, there was one dissenter (KC President George again), who wanted a quarter-point rate increase.
As of late, in the aftermath of Brexit, political uncertainty and lack of significant upside results in economic data like manufacturing and business spending, the calls for rate hikes have largely fallen silent. Based on the Fed’s own estimates, and a variety of economic departments, the chances of some kind of rate hike towards the latter half of this year lie around 50%. While September remains a possibility, December has looked to be at least equally likely, and, on the more extreme end, a well-known prominent firm or two have made predictions of no action until next year or even 2018.
A look at the dashboard of current conditions:
Economic growth: The advance GDP estimate for Q2 won’t be out for a few more days, but is expected to be in the admittedly broad 1.5-2.5% range, showing higher growth than a challenged Q1. The slowness of growth continues to baffle some economists, particularly concerning the input of low productivity, which appears to be a major headwind, rather than being a source of strength as in prior cycles. As it typically is, growth has become a key talking point in the political arena, where there are hopes of getting back to a renewed Reagan-era like period of optimism and prosperity. Whether that’s even possible or not are up for debate, as demographics appear to be against it, as are any impacts from hampering the engine of global trade through more protectionist policies. Some of these problems are obviously not popular political discussion points, since there are no easy or quick answers. While the ‘secular stagnation’ argument was at first looked at as a very out-of-mainstream view, it’s started to catch on somewhat. If that’s the case, the ‘lower for longer’ Fed policy stance may continue.
Inflation: As inflation is measured on a year-over-year basis for the most part, the substantial decline in energy prices continues to hold down the headline number to +1%. Core CPI, on the other hand, has seen some signs of normalization above the Fed’s 2% target, as services (including healthcare) and rents (actual and implied—via stronger house prices) have ticked upward. With lackluster economic growth and few price shocks, there hasn’t been much talk of inflation fears recently except on the fringes, as a world awash in accommodative monetary policy has pushed interest rates to negative levels—this would imply more fear of deflation than inflation.
Employment: As we’ve mentioned after prior meetings, labor markets have been a bright spot in the economic recovery. Unemployment rates have reached levels near ‘full’ and real-time measures such as jobless claims remain very low. It may not be feasible for these metrics to see dramatic improvement from here, so the watch is on for when they begin to eventually deteriorate (the signals of which ultimately lead to higher recession probabilities).
A key question is: where should interest rates be at this point in the cycle? The answer isn’t an easy one, especially considering the complicated forecasting tools and modeling of various ‘rules’ at the disposal of the Fed and other economists. The Taylor Rule is one starting point, the first of these types of rules which was developed by a Stanford economist in the early 1990’s, using inputs such as desired vs. actual inflation, current vs. ‘potential’ GDP growth, etc.; however, many other rules have developed since that time. A problem with these rules is that they all tend to come up with slightly to dramatically different outcomes, each of which appear to have sporadically worked or not based on the time period reviewed.
So, now what? The Fed remains concerned about a variety of things. The first priority is the set of U.S. economic conditions that naturally affect their monetary/inflation and employment mandates. Another, and one that’s been increasingly important in recent years is the impact of global financial conditions. While these technically shouldn’t matter for an individual nation’s central bank focused on internal policy, the globalization of markets has created tighter linkages, specifically in relation to relative currency levels and subsequent impact on trade, as well as the transmission of inflation pressures.
For major investment markets, though, the possibilities and challenges remain little changed. Fixed income investors are plagued by low yields, and are forced to use one or both mechanisms for improving returns or managing risk: (1) adjust maturities (or duration, specifically), or (2) adjust credit risk. We’ve discussed both many times, so these factors are not anything new. No matter the bond strategy, it comes down to these. For bond investors, these ‘sweet spots’ involve finding optimal yield curve locations and credit strata where one is being paid in proportion to the risk one is taking, as the ideal positioning from a valuation standpoint can change at points through the cycle. The highest-quality and shortest maturity segments on the curve provide the minimum amount of both types of risks, but you don’t earn much reward for such a position currently. Conversely, either venturing out on the yield curve and accepting a 2% yield for 30 years or delving down into the higher-probability-of-default areas of corporate debt contain their own risks should rates and/or business conditions (or commodity prices) change. Taking on a bit more credit risk and a bit less interest rate risk has been our modus operandi, and continues to look appropriate, although we’ve made some refinements over time.
Stock markets are affected by interest rates and Fed policy as well. This happens on both a technical and fundamental level. On the technical side, investors have been looking for return wherever they can find it, so low yields on bonds force movement to other assets where both yields and potential upside are higher (this has favored equities, as well as other peripheral areas like real estate). Fundamentally, lower interest rates mean lower discount rates, which affect how fair values are calculated—the lower the rate, the higher the present value since there’s essentially less opportunity cost to be rewarded for in the future. Both of these factors explain why equity valuations have crept higher, with a third reason being that earnings are expected to improve from flattish growth levels. There is simply less room for error in all of these factors than there once was, at least in the U.S. Foreign markets continue to be priced at more of a discount due to poorer sentiment about a recovery, and such situations can create relative opportunities.