U.S. monetary policy direction continues to attract debate, especially after a rocky start to 2016 but some key risks may lie elsewhere, according to investment experts from across BNY Mellon Investment Management boutiques - Standish, Newton and Mellon Capital.1
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There may not have been any surprise moves from the latest meeting by the U.S. Federal Reserve (Fed) but there was a change in tone as the Fed adjusts to the wider global economic and market volatility.
Following the 27 January monetary policy committee meeting, Mellon Capital’s Head of Investment Strategy Sinead Colton, notes the Fed did as expected and even its slightly more dovish tone was anticipated. Calling the Fed’s position “a balancing act” in light of added market volatility and weaker economic numbers, Colton believes it is unlikely the U.S. will see four rate hikes this year as was previously indicated.
Standish’s Deputy Chief Investment Officer David Horsfall agrees four rate hikes “sounds way too much” but he still believes U.S. rates are more likely to go up than down through the course of the year. He notes that while the Fed did indeed sound more dovish following the January meeting, the comments seemed more positive than in September when events in China and subsequent market volatility put a U.S. rate rise on hold momentarily. Still, he adds, as the Fed has become increasingly data dependant, how much interest rates move this year will rely on U.S. employment figures holding up.
The repercussions for the Fed to abruptly reverse direction are such that it is likely a higher hurdle for the Fed than to simply hold rates ...
Sinead Colton, Managing Director, Head of Investment Strategy, Mellon Capital
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Peter Hensman, Global Strategist at Newton, disagrees entirely. He believes the U.S. is as likely to restart stimulus as it is to raise rates through the year. He suggests the Fed should look at recent comments made by former Bank of England governor Mervyn King about what history now views as the Swedish central bank’s (Riksbank) error in raising rates in 2010-2011 and then having to sharply reverse direction after inflation remained below its target.2 Hensman notes that Lord King emphasises a significant error made by the Riksbank was to underestimate the importance of global events. Hensman inferred that the Fed could make the same error (if it hasn’t already), after all the stabilization in Chinese equity markets that helped justify the December increase has reversed and the so called ‘transitory’ declines in energy prices look increasingly permanent, he says.
However, Colton says the repercussions for the Fed to abruptly reverse direction are such that it is likely a higher hurdle for the Fed than to simply hold rates and issue more dovish commentary. In addition, she is sceptical as to the global implications of the Fed’s decision in December, noting it is hard to imagine a scenario whereby a 25bp hike derails the U.S. economy. “And if we move to a situation where the U.S. cannot withstand a 25bps rate hike then I think we would see more discussion about the U.S. moving into a Japan-type deflationary scenario.”
Horsfall says global growth has been so muted during the recovery and with U.S. rates so shallow in the first place, even a slight shift from an accommodative stance to being less accommodative could spark increased volatility. However, he dismisses the likelihood of policy error by the Fed and instead believes it more likely any such errors would come from China.
Colton too believes the downward trend in markets in the opening month of 2016 is more attributable to China and its growth prospects. While China’s growth has disappointed, part of the subsequent market reactions have been a result of the lack of transparency in the Asian giant’s economy and a misinterpretation by investors as to the news being received, she adds.
Colton, Horsfall and Hensman do all agree energy prices have not helped the situation. However, Colton notes oversupply in the energy market is not a sudden development. “OPEC members have really been producing significantly above their nominal production ceilings for quite some time,” she says. But the situation has been exacerbated by new energy producers such as the U.S. and Iran’s production coming back online coupled with falling demand from a slowing China. “I don’t see the oversupply situation correcting at least in the short term.”
Opportunities and risks
Horsfall says the knock-on negative implications of the oil price falls have hurt the high yield bond sector. Pointing out that returns from the high yield sector are heavily correlated with the oil price, he says it is hard to get excited about a sector where you know defaults are likely to rise. While he notes not all high yield is in the energy sector, he says it does place a drag on the asset class as a whole. He thinks it unlikely high yield spreads will come down until commodity prices stabilise or defaults do start to occur.
Horsfall indicates that selective opportunities may exist in high yield even with an unstable energy picture but, in general, he remains wary, for now. Hensman says the story is somewhat similar in emerging markets, noting there is increasing divergence across economies. He notes that Newton believes there are active management opportunities in careful selection of companies that benefit from falling input prices, have strong balance sheets and the flexibility to navigate challenging economic conditions. Colton adds that divergent policies globally can result in a significant rise of tactical opportunities across markets and asset classes.
In response to a question about risks to global economy Newton’s Hensman cites numerous possibilities including: the lifting of sanctions in Iran, the geopolitical stance of North Korea, a possible Brexit and the U.S. election. Colton agreed the possibility of a UK exit from the European Union (or Brexit) and its repercussions could be disruptive to markets as the year progresses and the closer any referendum becomes. In contrast, Horsfall says he will be closely watching U.S. consumer activity. A pillar of the U.S. economy, the consumer market has yet to show concerning signs of faltering, he says, adding if it does it could be detrimental not just for the U.S. but for global growth prospects.
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2 FT: ‘Riksbank frees its hands to intervene in currency market’, 4 January 2016
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Deputy Chief Investment Officer and Managing Director of Opportunistic Fixed Income, Standish
Managing Director, Head of Investment Strategy, Mellon Capital
Global Strategist / Economist, Newton Investment Management