Marcuard’s Market update by GaveKal Dragonomics
So far so good. Two hours’ trading, which was all the time New York markets had to react to the Federal Reserve rate hike, is hardly a significant sample, but the steadiness and consistency of that brief response must have left Janet Yellen satisfied.
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The most predictable and predicted event in financial history, turned out to be exactly that. The Fed did exactly what Yellen had suggested all year and what everyone by now expected—announcing a first “dovish” rate hike at the end of 2015. The reaction was equally predictable: a classic case of “buy the rumor and sell the news”, with the equity market reassured, junk bonds untroubled, long bonds almost motionless and the dollar trading comfortably within narrow ranges against all other currencies.
The only people who may have suffered any significant discomfort yesterday were the buyers of volatility, whether in equities, currencies or bonds. Assuming this calm market reaction continues in the five full trading days remaining before Christmas, as we would logically expect considering the care with which the Fed prepared this decision, we would suggest three broad economic implications and three more specific investment consequences for the year ahead:
Starting with economics, the Fed’s apparent success in managing this initial phase of the post-zero interest rate transition should increase Yellen’s market credibility in the year ahead. Investors will put even more trust in her moderately dovish forward guidance. The only significant adjustment to the Fed’s economic outlook yesterday came in Yellen’s statement that the “neutral” rate of interest should remain “unusually low” (we believe it is around zero in real terms according to the Fed’s internal model) and in the famous dot-plots, which showed interest rate predictions ratcheted down slightly, as a result of which market expectations for the next rate hike were deferred to April from March.
Given Yellen’s success in guiding market expectations for the year-end rate hike, investors will take more seriously the emphasis on achieving “maximum employment” which has been a mantra in all her public statements, and will pay less attention to the worries expressed by many private economists about US unemployment falling below estimates of the “natural” unemployment rate.
If the Fed is seen by investors as achieving its long-term policy objectives, a second broad implication will be greater confidence in the sustainability of the US expansion. If the exit from ZIRP continues to be as uneventful as the ending of quantitative easing was, the markets will be more likely to assume that the 2.5-3.0% real growth the US has enjoyed for the past five years will continue, and that inflation will accelerate to the Fed’s 2% target or somewhat above.
Thirdly, the Fed’s continuing dovish bias and its success in pursuing the maximum employment objective should encourage confidence in other economies where monetary and fiscal authorities are broadly following the US road-map, albeit with varying lags. Britain, Europe and Japan will all gain encouragement in patiently and predictably maintaining ultra-expansionary monetary policies for as long as it takes to achieve the desired results. The upshot is that global economic expansion should appear more reliable in 2016, and macroeconomic conditions generally more stable, than they were this year—the opposite of the outcome following Fed rate hikes that was widely predicted just a few weeks ago.
If the economic effects of the Fed’s rate hike turn out to be as benign as the initial market reactions, then three investment implications follow.
First and foremost, equity markets will again outperform bonds and cash, as they did during the risk-on periods in the first half of this year and from October 2011 until the end of 2013.
Secondly, risk assets should perform better in Europe and Asia than in the US, simply because a sustainable, but moderate expansion is now largely priced-in by US markets but not other markets, where the economic and monetary cycles are lagging several years behind the US.
Thirdly, the US dollar will stop rising and perhaps weaken slightly against the yen and the euro, as investors come to recognize that they have wrongly assumed that the start of the Fed tightening cycle necessarily implies a stronger dollar. This tightening was totally predicted and discounted which has not generally been true preciously, and in any case, no genuine correlation between the dollar and monetary tightening has existed in the past.
These have been the big investment themes that we have suggested since the markets got over their summer panic about China and at least in the first few hours of trading immediately after the Fed’s historic rate hike, they seemed to be working out.
