The Fed Dominates the Picture in 2019
Lord Abbett's Investment Perspectives
The Fed Dominates the Picture in 2019
A Roundtable Discussion - Part 2
Joseph Graham: Do you think - and Leah we can start with you - do you think in 2019 we see continued rate hikes in the United States? And does that go into other developed markets? Or do you think they [the U.S. Federal Reserve (Fed)] take a pause in reaction to some of this increased volatility?
Leah Traub: I think growth is decelerating a little bit from the peak growth that we saw in the second quarter and then into the third quarter. And we're seeing a little bit of deceleration. But it still will be relatively strong growth in the United States. Inflation is kind of right around target. I think [the Fed] can hike a couple more times.
If we do see more significant weakness, [the Fed is] looking more towards global growth. That has come back into their narrative in the last few weeks. And they're looking at some of the weakness that has been more persistent in places like the eurozone - more persistent than expected. So the expectation is for growth outside the United States to rebound a little bit. But if we don't see that, and we see continued weakness, then sure, I think the Fed may take a pause.
Or they may go a little bit more slowly. But the outlook right now, I think, has to be that they're still going to hike a few more times.
Graham: Okay. And then there are other X factors, things like a hard or soft Brexitâprobably something that investors are concerned about and could influence Fed policy going forward. And then the Italian budget situation. Giulio, do you think those are big risks that we should be aware of next year? Or do you think they're overblown? How do you see those two risks?
Giulio Martini: Well, I think those are really sideshows to the main event in a lot of ways. The market has really priced in [the] Brexit scenario and the slowdown in growth of the economy in Great Britain that would go along with that by really moving the pound much lower, with respect to other currencies immediately after the Brexit vote was taken and keeping it in a relatively weak position since then.
And, you know, the Italian situation has actually been showing signs of improving recently. But I think those ultimately are kind of sideshows to the main event, which really is the Fed in my mind. And what's changing is, we know that the Fed can tighten and still have the economy perform well and the markets do well. They first signaled a change in policy in 2013. They started to raise interest rates at the end of 2015. They've raised interest rates [a number of times since] the end of 2015.
And we've had very strong markets and a strong economy since then. What's changing is that investors are uncertain what the trigger point for moving into a restrictive rate environment is. In other words, there's a concept of the natural rate of interest, which is the interest rate at which the economy can grow at its long-term trend with stable inflation. And there's been a view that [the natural rate is] around 3%.
And so, up until now, the Fed has really tightened in an environment where mostly it's been well below what's thought to be the natural rate. But now we're getting closer. And it could be that the next tightening move, or the one after, could even take us above the natural rate. And the economy would really start to struggle to continue to grow as rapidly as its grown up until now. And the markets would have more of a problem dealing with that.
So it's really the cumulative effect of all these rate rises that's starting to weigh on investors, more than anything else, with spillover effects to the rest of the world. Because, ultimately, the United States is still the largest economy in the world. It's still the engine that pulls the train of the global economy. Although there are some economies that are getting closer, like China, where growth really matters on a global scale now.
But ultimately, I think the point at which monetary policy becomes restrictive has gotten closer and closer. And as that's approached, and as this business expansion has aged - it's likely to become the longest ever in U.S. history - I think investors have started to really worry about the potential for slowing economic growth to create an environment in which it's much more difficult for corporate earnings to grow.
Graham: You bring up a really interesting point on the business cycle and something that, in my travels, investors are very concerned with.
Kewjin Yuoh: So if you think about where we are in the cycle, if you look at the data, if you look at the soft economic data, which includes consumer sentiment [and] manufacturing [sentiment], these are all very strong. And they've been on uptrends for the last six months. If you look at the hard economic data, you talk about the labor picture still being as tight as it is and as strong as it is.
You talk about inflation, which it had started to creep up, but as [the consumer price index (CPI)] has come back to a 2% line, which is right at [the Fed's] target and really presents no challenges right now. And if you look at industrial production, industrial production has been reasonably strong.
When we think about the potential end of the cycle, you can look back to early 2016, when we had [energy and oil] shocks [and] China concerns. And at that time, if you looked at the economic indicators, they really were on a downturn for the previous seven to eight months. That's just not the case right now. So if I think of the end of [the current] cycle, I still see it a protracted period of time away.
Graham: If you look at forward price-to-earnings [ratios], compared to how much those earnings are forecasted to grow, it seems like there's some skepticism built into the market. Would you agree with that, Tom?
Thomas O'Halloran: I think the market is concerned about the pace of Fed tightening. We're really in uncharted waters here. We have never had a monetary experiment like this in history. The Fed balance sheet expanded from $800 billion to $4.6 trillion. And that was the fuel for the equity markets for most of the past 10 years.
Now that's ending. And what will be the pace of the tightening is a very important issue. And that will impact the equity markets. I think that the Fed is not going to raise rates as much as the market expects. I think that they will tap the brakes. Because I don't think that they can get away with it without hurting equities more.
But I'm very bullish, you know, in the intermediate term on equities. As Kew and Giulio point out, there are reasons to continue to be optimistic about the health of the economy for a while longer. Inflation is under control. And, as I discussed the last time, the technology revolution is a very powerful and healthy force for equities, [one that is going to] last for decades from now.
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CPI refers to the Consumer Price Index, which measures changes in the price level of a market basket of consumer goods and services
purchased by U.S. households.
Fed refers to the U.S. Federal Reserve.
Federal Funds Rate (fed funds rate) is the interest rate at which a depository institution lends immediately available funds (balances at the Federal Reserve) to another depository institution overnight.
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