By: Guy Adami, Director, Advisor Advocacy
Published October 3, 2018
Rising interest rates. Trade tensions and tariffs. The yield curve flattening at a seemingly alarming rate. What can we glean from looking at historical performance as we move forward? Guy Adami, joined by Doug Peebles, Partner and Chief Investment Officer of Fixed Income at AllianceBernstein, lend their expert opinions in this month’s financial market update. AllianceBernstein has recently been added to Private Advisor Group’s Strategic Partnership program.
A lot of interesting things are going on in the markets; 2018 has been a great transition year. Central banks have shifted from Quantitative Easing to Quantitative Tapering, resulting in a normalization of policy and tighter credit conditions. But what does all of this mean?
Looking back in the post-crisis environment, we had a situation where central banks effectively created enough currency to buy back assets. That was, frankly, a marvelous backdrop for investing in financial assets. For most of the time period between 2008 and 2017, the global economies didn’t do so hot. We had really underwhelming growth, but we had outsized return on all assets. It was a bonanza for asset prices. We have a situation now where it’s a transition year between quantitative easing and quantitative tapering.
Two Elements of Major Economic Impact
In 2017, the Fed did zero. They didn’t buy back any bonds, and they didn’t redeem any. We had 1.4 trillion dollars worth of QE by the Bank of Japan and the ECB. And this year we think between the three central banks, now that the Fed has turned and they’re letting the bonds roll off, we’re going to have 300 billion in QE. The real question is, do you believe in the stock or the flow? Doug is of the opinion that financial markets operate on the flow, and the 1.1 trillion drop matters a lot for financial assets. This is the backdrop of today’s discussion and the most important macro element.
The second most important macro element is the U.S. tax cuts and the spending package. These have created an environment where the tightening by the Fed, both in adjusting balance sheet and raising interest rates, is more than justified on the back of the U.S. economy which is now running hot. We have never seen this big of a fiscal thrust in the U.S. on an economy operating on full employment, and it’s going right to the bottom line. The U.S. economy is humming resulting in the Fed appropriately tightening monetary conditions in the U.S. Maybe not tight enough for the U.S. but too tight for many players outside the U.S., and front and center is emerging markets.
Policy and Rhetoric from Current Administration a Concern?
Doug is of the opinion that the policy in place remains supportive of the U.S, maybe for a few more quarters. If the valuation of non-U.S. equity markets haven’t corrected enough, then there’s still room for that to widen just on the back of momentum. In the short term, he is concerned about market positioning. Where are the classic underweights and overweights in these crowded trades?
Guy posed a question about the current administration’s commentary on rates and the Fed. Doug is of the opinion that this is the new normal. If the president didn’t want the Fed to raise rates, the tax cuts shouldn’t have been implemented. We needed them back in 2009 and 2010. But this is the “second grand experiment,” says Doug. First is the central banks; what will the withdrawal symptoms be in the QT world? Second is this massive fiscal thrust on an economy of full employment. The Fed is simply reacting to this stimulation with corporate tax cuts and extra spending increases.
Tariffs and Trade War
No one has a real handle on what the outcome will be regarding the trade situation with the Chinese. How will potential trade war with China impact the buy market? At the margin, Doug says, it has two big direct impacts. First is that the Chinese trade surplus is going to shrink. The Chinese have an enormous trade surplus with America, but not with the rest of the world. Their overall trade numbers are going to slow, which will slow their accumulation of dollars and negatively impact the number of dollars they have to reinvest in trade. The second direct economic impact it will have is that U.S. importers are going to pass on some of the higher costs. If you look at the goods price inflation for U.S. economy it’s still negative; we don’t have this inflationary boogeyman coming around the corner because of these trade sanctions or the tariffs, but it will at the margin cause inflation to be slightly higher.
This all puts the Fed in further solid ground for continuing to tighten policy. But we still have negative interest rates. It’s not like we have a tight policy, just tighter than it has been. What the Fed is trying to do is snug up financial conditions. Doug suggests keeping an eye on the Chicago Fed Financial Conditions Index. If you look at this index, you’ll see it is more loose and stimulative now than when the Fed first raised the interest rates in December of 2015. This is an important element in why the Fed is going to remain on course.
Final Thoughts on the Yield Curve
We’ve established that regardless of what the yield curve does, rate trajectories continue to be higher. How do you defend or play the rising rate pressures we are seeing in the marketplace?
Doug suggests a couple of ways to do this. 1. Keep durations shorter. You want to keep it short but not as short as back when rates were less than half of what they are now. 2. It helps to go global. We discussed the impact of tariffs on China, but you know who has a much bigger trade surplus than China? Germany. German rates are low right now. And finally, 3. For taxable investors, remember that the municipal market is not behaving the same as the taxable market.
Find out more about the PAG Market Update calls and to tune into the next call which will discuss market conditions post mid-term elections.