Cyclical traction points to reduced U.S. monetary accommodation
Developed market equities have continued to outperform their emerging market peers on the back of better manufacturing and services data in the U.S. and Europe. The latest ECB lending survey indicated a less severe credit crunch in Europe and improving credit demand. In the U.S., a resilient July ISM Index is a plausible tailwind for commercial and industrial loan growth. U.S. labor market data remain supportive i.e. in a zone of 150k-200k monthly job growth. Looking ahead, September is likely to be an important month for both fiscal and monetary policy. In Washington, Congress will have to deal with the fiscal year 2014 budget and the Federal debt ceiling. At the Federal Reserve, despite a dovish July FOMC statement, policymakers will likely have to weigh the pros and cons of maintaining the current pace of monetary accommodation. The Fed has the challenging task of striking a tight balance between economic growth and financial stability. From our perspective, with a sticky 10 Year Treasury yield at 2.65%, we prefer to avoid any potential interest rate volatility. Thus, we continue to shy away from longer duration fixed income instruments.
As we can see below, the U.S. economy is rebounding from a cyclical trough in the first half of 2013. The U.S. trade balance continues to improve as a result of higher export demand and lower oil imports. Moreover, developed market economies are showing sequential improvement, as shown by the G10 economic surprise index. In the U.S. equity market, the Transportation Index seems to be confirming this cyclical traction. Moreover, the Industrials sector has continued to outperform. On the fiscal side, with cyclically improved budget and trade deficits, we could see a more constructive discussion in Congress e.g. on business confidence positive factors such as immigration and corporate tax reform. Perhaps the main area of contention will be the Affordable Care Act. Thus, we are cautiously optimistic for another leg down in public policy uncertainty; which could provide further confidence to businesses, households and risk assets such as U.S. equities.
On the U.S. monetary front, five years after the 2008 credit crisis, the Federal Reserve finds itself at a crossroads. The Dallas Fed president Richard Fisher recently described the Fed’s balance sheet position as a Gordian knot. He noted that the Fed holds 20% of the stock of US Treasuries and is buying 25% of gross issuance of notes and bonds. In addition, the Fed holds 25% of mortgage-backed securities outstanding and is responsible for 30% of gross new MBS issuance. In our view, despite any potential medium-term volatility, the Fed should gradually start the normalization process. The corporate and household balance sheets are at an advanced recovery stage. Collectively, the private sector has sufficient surplus savings that can fund the next leg in the business cycle. From a technical perspective, by absorbing a greater amount of Treasury issuance, the Fed appears to be squeezing collateral liquidity in the repo market. Lastly, with a smaller budget deficit and reduced Treasury needs, the Fed is probably better off to taper in order to avoid criticism of debt monetization.
Labor market conditions are one of the key Fed metrics. The labor market has continued to improve and weekly jobless claims are pointing to a lower unemployment rate. To be sure, labor market conditions are far from perfect as the labor participation rate has been declining and wage growth has been subdued. However, we note that unemployment and inflation measures are lagging indicators. With a depressed velocity of money and nearly two trillion USD in excess banking reserves, there is a risk of a sudden pick-up in inflation in the future if economic growth accelerates notably. Thus, we see more reasons for the Fed to slowly start its normalization process. From a portfolio perspective, we prefer a low duration exposure to non-agency MBS and we continue to avoid longer duration fixed income asset classes e.g. closed-end bond funds. In equities, we continue to avoid interest sensitive sectors such as utilities. We prefer cash rich sectors such as healthcare, technology and late-cycle sectors e.g. industrials and energy.
In conclusion, we are encouraged by the recent cyclical rebound in developed market economies. We are assessing the evolution of the current business and credit cycles. We remain nimble in allocating capital in asset classes that offer cash flow and earnings visibility.
Christos Charalambous CFA
Senior Strategist
christos.charalambous@edgewealth.com
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