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Framing the "What Ifs" for 2019

By: Philip Lawlor, managing director, global markets research

As a turbulent 2018 draws to a close, markets face a very different investment landscape than what has prevailed for most of the post-crisis era. This stage in the cycle calls for a clear-eyed assessment of the potential risks that could upend long-held assumptions and catch markets off guard.

A case in point: Is there too much complacency about the future trajectory of US interest rates?

The persistent gulf between market-driven rate forecasts and those of Federal Reserve rate setters suggests that investors remain skeptical that the central bank will stick to its proposed tightening path, as laid out in its dot-plot projections (Chart 1).

Such skepticism has served investors well over the past decade, as similarly sudden spikes in response to nascent signs of inflation were quickly followed by equally swift contractions as inflationary pressures abated.

However, there is clearly a risk that the tightening US labor market (buoyed by the boost to aggregate demand from Trump’s tax cuts) has now reached an inflection point. US wage growth has posted sequential increases over the past few months and now looks to be breaking to the upside.

As we see it, a big question facing investors is what probability they would assign to US wage growth moving to a level that would trigger a different Fed and market reaction? As the chart below suggests, wage growth would not have to climb much higher from current levels for the narrative around cost-push inflation to change. Is the market relying too heavily on the persistence of a Goldilocks economic outcome and, thus, ascribing too low of a probability to this tail-event risk?

 

Another tipping point to watch

History tells us that there is a tipping point at which monetary policy morphs from being seen as gently “tapping” on the brakes (still accommodative) to being viewed as restrictive, with each successive hike seen as “slamming” on the brakes (Chart 3). That point has typically come when nominal interest rates exceed 50% of nominal GDP growth. The chart below shows the spread between nominal GDP and US Fed funds rates, an extrapolation of which would indicate that this tipping point is not far away.

 

Our proprietary, multi-metric Financial Conditions Indicators (which consider moves in currencies, bonds, interest rates and other variables) has seen the US composite score rise to a level just below 4 over the past year (Chart 4). A move from 3 to 4 is deemed as tightening, while a move above 4 would be deemed as tight and regarded as a potential headwind for equity returns. This contrasts starkly with the still accommodative scores for the Eurozone and Japan.

 

 

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