Uncertain monetary policy in spite of a low inflation backdrop
Financial markets continue to assess the likely path for central bank policies, in the context of low global growth and disinflationary undercurrents. Following recent mixed signals from the Federal Reserve, investors have been preoccupied with the prospect for monetary stimulus tapering. As a result, the U.S. Treasury market, other sovereign bond markets and credit sensitive debt instruments have seen rising yields. Moreover, emerging market equity and debt markets have underperformed due to the prospect for capital outflows and current account imbalances. From our perspective, we remain positioned in low duration non-agency MBS, which fundamentally benefits from a recovering housing market. In equities, we maintain our late-cycle/secular growth tilt with a preference for cash rich sectors such as healthcare and technology.
As we can see below, real rates and nominal bond yields have been on the rise. At the same time, inflation expectations have been decreasing. Global growth remains uneven and inflation remains subdued. Despite reflationary efforts by global central banks, global inflation remains low due to the low global growth environment. In addition, the growth slowdown in Emerging Markets and China seems to be the culprit for softening demand for commodity prices. In developed markets, ample labor supply is also a dominant factor in keeping wage increases in check. In the U.S., despite extraordinary monetary expansion, core PCE inflation is near its multi-decade lows, around 1%. This is well below the Federal Reserve’s target of 2%. It is plausible that the Federal Reserve will attempt to normalize its policy on the margin in the coming quarters. Yet, as inflation is very low and the global growth outlook remains uneven, we do not expect a dramatic U.S. monetary policy shift that would jeopardize the U.S. economic recovery. However, after an unprecedented monetary policy stance in the past four years, we expect some policy uncertainty to weigh on interest sensitive asset classes.
To be sure, as we argued in past articles, monetary policy alone is not a panacea and there are externalities to a financial repression environment e.g. over-reaching for yield and asset price inflation beyond what fundamentals would justify. To a fair degree however, the Federal Reserve has contributed to the stabilization of the banking system and with its easing stance has contributed to the housing market recovery and household debt deleveraging efforts. Labor market conditions remain stable but we highlight the lack of wage growth and the low labor force participation rate. Unfavorable demographic trends (Baby Boomers retiring) and job growth in low-skill sectors (e.g. retail, leisure & hospitality) are keeping wage inflation in check. Looking into the second half of 2013 and into 2014, we expect some fiscal headwinds on labor earnings due to government furloughs and some business cautiousness due to the increased costs of the Affordable Care Act. Thus, we remain cautious on retail spending and we prefer exposure to global corporate spending via investments in the technology sector e.g. software and business analytics.
On the global growth front, we note that the current backdrop remains uneven. In Europe we are observing subdued but marginally improving data. In Japan, as a result of its extraordinary monetary expansion, recent GDP growth (Q1 2013) has been strong at an annualized rate of 4.1%. On the other hand, the growth slowdown in China continues and sentiment on emerging market growth remains negative. The debate is whether current account imbalances and the risk of capital outflows may increase credit strains. In the U.S., despite increasing confidence levels, we continue to see some softness in the manufacturing sector. The leading manufacturing indicator of ISM new orders less inventories, points to weak growth momentum. On a more positive note, we continue to see steady growth in the U.S. services sector.
Lastly, we highlight the ongoing disinflationary trends in China which emanate from the country’s growth slowdown. Along with the strengthening Yuan, we expect the shift to domestic Chinese consumption growth to continue and with increasing purchasing power we expect our global healthcare investments to benefit.
In conclusion, we continue to assess the global growth outlook and we are on the lookout for pivot points in central bank policies. From a bottom-up perspective, we are opportunistic in adding exposure in financial instruments that offer earnings and cash flow visibility. We maintain our preference for income themes and late-cycle/secular growth exposures.
Christos Charalambous CFA
Senior Strategist
christos.charalambous@edgewealth.com
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