The Outlook for Interest Rates, the Economy and Inflation in the U.S. and Among the Other Major World Economies

The U.S. Fed will probably start shrinking its balance sheet in September and the ECB is likely to taper its asset purchases in the first half of 2018. What is the outlook for interest rates, the economy and inflation in the U.S. and among the other major world economies?

Beginning with the United States, data indicates that the Fed’s balances sheet may remain substantially higher for longer and that interest rates may remain substantially lower than would have been considered normal before the crisis.

In the twenty years ending 2007, Fed funds averaged 4.85%¹. In September 2007, the Fed started cutting interest rates until it reached 0.25% in December 2008¹. The Fed wasn’t ready to cut further into negative rate territory which left them with an economy needing stimulus while their preferred tool was exhausted. Instead, the Fed embarked in Quantitative Easing (QE), large-scale asset purchases, which dramatically expanded its balance sheet.

Though the Fed has not added to its balance sheet since 2014, it has been reinvesting the interest and principal payments received to maintain the balance sheet at a steady level. Asset purchases as a monetary policy tool is new in the U.S. and allowing the assets to mature may have an unknown affect on the economy.

There is a risk of tipping back into recession if the unwinding begins when growth is too weak. The Fed’s normalization statement pointed out that while it expects to use the federal funds rate to fight recessions, the FOMC may restart reinvestment in the event of substantial interest rate cuts.

After the Fed reduces its balance sheet, rates would likely remain low. The U.S. trend growth rate is believed to be about 2% per year. The FOMC’s poll of its own voting members expects longer-run growth to be in the range of 1.8-2.0%, which is in line with the trend growth rate. For comparison, for 20 years ending 2017, GDP annual growth averaged about 3%¹.

As we discussed in our White Paper 3, the expectation for lower average growth in the years ahead is due to low productivity growth and the aging demographic. The productivity slowdown is a new phenomenon that is not entirely understood and it is possible that productivity acceleration could result in a pick-up in growth eventually. For now, slower trend growth will contribute to lower interest rates in the years ahead than in the period before the crisis. The aging U.S. population is also a factor as increased savings make their way into the fixed income market.

 

Themes

1.  A Mixed World Economic Outlook

Advanced economies grew fairly rapidly in the second quarter, with GDP growth likely to have rebounded strongly in the U.S., Japan and the UK and to have accelerated a little in the euro-zone. This in turn has led to a further reduction in the aggregate unemployment rate in advanced economies. However, there is little sign that wage pressures are rising.

While Japan and the UK saw downward revisions to Q1 growth, the economic growth in the euro-zone was revised up. The euro-zone has now recorded three consecutive quarters of accelerating GDP growth. The recovery in advanced economies as a whole has been driven largely by consumption. Investment spending has also recovered in nearly all major advanced economies, but particularly in the U.S. and euro-zone. Industrial production has generally expanded at a decent pace in recent months. Among the emerging economies, China growth edged up in May for the first time this year.

A synchronized shift in monetary policy swept across bond markets in June with hawkish central bank chatter pushing bond yields higher across Canada and Europe. These moves spilled over to the U.S. bond market despite the slow-moving Republican agenda, soft economic results, and muted pricing pressures.

Global monetary conditions remain loose despite continued tightening by the U.S. Fed. Policy rates in major advanced economies are still exceptionally low. Policymakers in the ECB, Bank of England and Bank of Canada made comments prompting a sell-off in bond markets towards the end of the quarter, but the increase in bond yields was small compared to the move after the election of Donald Trump.

Growth in lending to firms has been steady in the euro-zone, at about 2% year over year². However, there are big differences within the region with lending still contracting in Italy, reflecting the weakness of its economic recovery and the country’s troubled banks.

The Bank of Canada shows confidence in the Canadian economy by raising rates by 0.25% to 0.75% in July and signalling further removal of policy stimulus in the future. Canada has been a leader of major changes in the global monetary system in the past. In 2015, its rate cuts helped kick off a global trend that saw countries accounting for almost half of global output including China, Denmark, Sweden, Indonesia and Australia. Canada is in the midst of one of its strongest growth spurts since the 2008-2009 recession, with the expansion accelerating to over 3% over the past four quarters³.

The Bank of Canada highlighted in its statement that the recent economic data has bolstered their confidence in the “economic outlook for above-potential growth and the absorption of excess capacity in the economy.⁴” Low borrowing costs are fuelling housing prices and household debt is hovering at record levels. Similar to the United States, the labour market has been strong, with the unemployment rate at the lowest since before the recession. Though inflation has not increased, the Bank determined that recent softness in inflation is only temporary and that it will rebound.

The collapse of oil prices that trimmed $60 billion annually off Canada’s national income prevented the Bank from following the Fed in raising rates beginning 2015³.

The Canadian economy appears to be on the verge of a slowdown due to housing-related weaknesses, which is reinforced by higher household borrowing costs. The surging Canadian dollar over the past month as the U.S. dollar weakened would also add to the shift to tightening. The same questions around stagnant inflation apply in Canada and elsewhere.

 

2.  U.S. Growth Slows:  Delayed Fiscal Stimulus and America Alone

Sentiment in the United States economy contradicts recent economic data. While businesses and consumers are positive about the future, economic activity has not been coming in strong. Several surveys report that chief executive officers are highly optimistic, however, M&A activity is at its lowest level since 2013, and has fallen 40% in the past two years⁵.

Share buybacks has slowed and capacity usage has fallen, both indications that CEOs are less confident in the future of their businesses. The University of Michigan’s Surveys of Consumers show confidence at the highest levels since before the crisis. Meanwhile, retail sales fell in May and have been relatively lackluster for the year so far⁵.

The drop back in core PCE inflation to a 17-month low of 1.4% in May has led to expectations that the Fed will hold on raising interest rates⁶.

The Fed’s 2% inflation target looks more like a ceiling since core PCE inflation has only exceeded that level 24% of the time since 1995⁶. Core inflation has been above target only 6% of the time since the target was adopted in 2012⁶.

As we discussed last quarter, a fundamental shift in trade policy over the next four years is being proposed by the new administration to stem the further outsourcing of manufacturing production and employment abroad this year.  The reality is that only a small fraction of the five million lost jobs could conceivably return since China’s shift 15 years ago to largest importer to the WTO. Additionally, assuming the U.S. becomes more aggressive in initiating disputes at the WTO, other countries could retaliate by bringing their own claims. Meanwhile, the boost to the domestic manufacturing sector should be minimal if these new trade policies trigger a further appreciation in the dollar.

 

3.  Global Low Yield Environment Ends Unevenly

The U.S. Fed will probably start shrinking its balance sheet in September and the ECB is likely to taper its asset purchases in the first half of 2018. The U.S. reflation trade has been delayed by muted wage growth and uncertainty about fiscal policy, but the prospect of ECB normalization is now pushing global yields higher.

The biggest impact of globalisation on interest rates driven by inflation has come through the deflationary effect on traded goods prices, particularly durable goods prices, which have been declining since the late 1990s.

The flattening of the Phillips curve is usually attributed to globalisation, well-anchored inflation expectations, the decline in union power and increases in labour flexibility. This is a global phenomenon. In addition to the United States, low unemployment rates in the UK, Germany, Japan and Canada have failed to spark any meaningful acceleration in either wage growth or core price inflation. Globalisation has undoubtedly played a key role, particularly the entry of China into the global economy.

While China has been an integral part of the global trading system for more than a decade now, the rate of decline in goods prices shows no signs of easing. As a result of globalisation, goods prices now tend to be driven by global economic factors, as much as domestic U.S. factors, which contributed to the flattening of the Phillips curve. However, globalisation and technical progress have had a much smaller impact on services prices.

The rate of service price inflation fell sharply during the 1980s and early 1990s, but that was mainly due to better anchoring of inflation expectations, as the Fed built its credibility as an inflation-fighting central bank. Since the mid-1990s, services price inflation has been more stable. Most recently, housing and other services inflation has been accelerating as expected given the gradual elimination of slack in the labour market. However, health care price inflation has continued to trend lower, which accounts for almost 20% of the core PCE⁶. This explains why core PCE inflation appears to have reacted less to shifts in the output gap in recent years.

 

4.  U.S. Dollar Depreciation

The US dollar has continued to depreciate on a trade-weighted basis in recent weeks, despite another increase in the federal funds rate. It is now around 5% lower than its value at the turn of the year. In June, it fell against all major advanced-economy currencies except the yen. We expect this to continue as the implications of the United States no longer leading in coordinating global trade and climate change, and as fiscal stimulus is delayed due to political headwinds are factored into the currency price.

With these themes in mind, we will continue to monitor economic data for traditional slow growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics.

Frame Global Asset Management considers these trends and factors them into our outlook for the economy in our twelve-month forward period. We look back to periods of similar economic behavior and use this information to predict the future behavior of the asset classes that we consider. Our investment process allows us to adapt for non-traditional monetary policy and other exogenous variables.

 

Deborah Frame, CFA, MBA

President and Chief Investment Officer

July 15, 2017

 

¹ ETF Trends.com, Fed Outlook H2 2017, July 7, 2017.

² Capital Economics. Global Economics Chart Book. July 6, 2017.

³ Bloomberg.com. Your Guide to the Bank of Canada’s Bellwether Rate Decision. July 12, 2017.

⁴ Capital Economics. Canada Rapid Response. July 12, 2017.

⁵ Bloomberg.com. Why Americans Feel So Good About a Mediocre Economy. June 26, 2017.

⁶ Capital Economics. US Economics Weekly. July 7, 2017.

When does inflation begin to change investment decisions?

During the first quarter of 2017 we removed U.S. inflation from our outlook and reverted to Stagnation for all global economies for the twelve-month forward forecast. Looking to the future, our analysis suggests that ongoing monetary accommodation is unlikely to have significant inflationary consequences, if inflation expectations remain anchored. As we enter the second quarter of 2017, we are redefining our Inflation environment to U.S. CPI¹ greater than 3.5%, up from the previous 2.7%. We will review this as the economy grows, and as underlying inflation and interest rates move higher.

With U.S. macro data coming in strong and further evidence that price pressures are building, the uptrend in bond yields appears likely to continue.  As the focus of rising yields is primarily to manage the rate of growth of an economy and inflation, we believe it worthwhile to review the traditional and current relationships between growth, productivity, inflation, bond yields and equities. The recent rising trend in bond yields has been positively correlated with continued gains in equities, which we relate to a low inflation environment.

Advanced economies have experienced a prolonged episode of low interest rates and low growth since the global financial crisis. From a longer-term perspective, real interest rates have been on a steady decline over the past three decades. Despite recent signs of an increase in long-term yields, particularly in the United States, the experience of Japan suggests that an exit from a low interest rate environment does not come with a play book. A combination of slow-moving structural factors, including population aging and slower productivity growth currently plaguing many advanced economies, are generating a steady state of lower growth and lower nominal and real interest rates in these countries. With the second Fed hike in December and the expectation that the Fed will soon begin to shrink their bond portfolio, the market will judge whether the tighter financial conditions will impact growth. Challenging the impact of the rate hike is the impact of the stronger U.S. dollar.

U.S. Payroll employment started the year on a strong note, with monthly gains in both January and February well above 200,000².  Rising labour costs helped drive core inflation above 2% but these costs are rising faster than selling prices in the non-financial corporate sector.  Is the U.S. economy growing fast enough to support higher interest rates?

Expansion of central bank balance sheets has produced a multiplier effect on U.S. equity returns. This has impacted confidence which fed into soft data, namely business and consumer confidence, the measures of expected growth for the U.S. economy and inflation. Hard data, such as payrolls and industrial production, have not been as encouraging. The gap between “hard” and “soft” data measuring the U.S. economy has never been wider³.

 

Rising Yields from Low Levels Remain Friendly for Equities

A slowdown in productivity tends to be deflationary at the outset and inflationary later. Initially, lower productivity growth reduces investment, pushing down aggregate demand. Lower productivity growth also reduces consumption, as households absorb smaller real wage gains. Stabilization of inflation may imply a shift in economic volatility to other variables, helping generate asset-price booms by making borrowing and risk-taking more attractive. It may also raise the return to capital by restraining wage growth.

 

There is good reason to question the view that lower unemployment will push wage growth substantially higher in the current environment.

 

 

Such results could be explained by the fact that in a very low yield environment, higher yields are perceived as an indication that the economy is improving, which also benefits equity prices. Central banks have debated what the inflation target should be. The first inflation target was adopted by the central bank of New Zealand in 1990. The Fed used an unofficial inflation target until January 2012, when it announced that it thought a policy which targets a 2% rate of inflation is consistent over the longer run with the Fed’s mandate⁴.  Looking ahead, three structural forces look set to keep us in this low yield environment over our forecasting time horizon of the next twelve months; technical change, flexible labour markets and globalization. We examine this question in further detail in our third Whitepaper available on our website.

 

How should the Fed respond?

Two Federal Reserve Board economists, Michael T. Kiley and John M. Roberts, suggested three ways for the Fed to avoid zero interest rates as much as possible⁵. We prefer their suggestion to set the inflation target above 2% with the Fed keeping an eye on the weighted impact of all capacity constraints currently present. This is based on our recent conclusion that structural forces will prolong the deflationary forces currently in play.

Headline inflation in the developed world is likely to rise in early 2017, due largely to rising oil prices and a generally firmer global backdrop. Underlying inflation would rise slower as above-trend growth eats away at available slack. Interest rates will likely remain low in many economies, and will not rise substantially in the U.S. in the coming years.  A year ago, a drop in aggregate demand caused a decline in global goods prices.  Stimulus from the BOE, ECB and BOJ was used to fight this trend and contributed to growth.

The recent rebound in inflation is attributed to previous falls in oil prices, a process which has now almost finished. Long-term inflation expectations pulled back in most advanced economies over the past month while headline CPI inflation in major emerging economies continued to fall in February. Emerging markets still struggle while bigger economies are stabilizing.

We conclude that pressures on productivity and demographics will keep inflation pressures and growth in the U.S. and globally at levels within our Stagnation Environment definition for a period extending well beyond our twelve-month forecast horizon.

 

Themes

1.  A Brighter World Economic Outlook

The world economy has entered Q2 in better shape than it exited 2016. It has now been confirmed that global GDP growth accelerated in each quarter of 2016 and was close to 4% in Q4. However, there is still notable divergence in performance among G7 economies. The United States, U.K. and Germany grew by an expected 2% annualized in Q1, while France and Italy are expected to have grown at around half that pace.  In the euro-zone, production grew by nearly 1% in January, and industrial output in Japan has surged over recent months.  The latest output data for the major emerging economies have been mixed. GDP trackers point to a renewed downturn in Russia while information out of China suggests that the improvement in growth seen over the past year or so has fizzled out.

Headline inflation has rebounded in every major economy. In developed markets, monetary easing is on it’s way out while emerging market central banks plan to continue cutting their policy rate.  Among central banks this year, 13 have cut their interest rates while five have raised them⁶. The unweighted global average policy rate dropped below 2%, an all-time low, while world inflation jumped to 2.5% due to energy prices, resulting in negative real global policy rates⁷.

The unemployment rate in the OECD fell to 6.1% in January, its lowest since 2008⁸. Employment growth has slowed in the U.K. in recent months, but has continued at a steady pace elsewhere. Euro-zone employment has finally recovered to levels seen prior to the global financial crisis.

The IMF published its twice-yearly health check on the world economy. The outlook has brightened considerably since an interim forecast in January. Signs of stronger activity are visible in both developed and emerging markets. Forecasts for worldwide GDP growth are expected to be revised upwards.  Christine Lagarde of the IMF recently noted that after six years of disappointing growth, the world economy has a “spring in its step”. The outlook could be revised because of political uncertainty (Marine Le Pen might win in France), protectionism (Donald Trump might start a trade war) and tighter global financial conditions (the Fed might raise interest rates too quickly).  For the first time since the recession, there are a lot of things going well.

 

2.  U.S. Growth

The latest data indicate that first-quarter GDP growth was relatively subdued at 2% annualised. That said, a lot of the weakness can be traced back to a sharp drop in utilities demand stemming from the unseasonably mild winter. The sudden post-election weakness in bank lending is a concern. Most of the market and media attention has focused on business loans which, after growing at a double-digit annualised pace between 2014 and late 2016, have suddenly stagnated while other major loan categories also show a marked slowdown in growth since last November.

A fundamental shift in trade policy over the next four years is being proposed by the new administration to stem the further outsourcing of manufacturing production and employment abroad this year.  The reality is that only a small fraction of the five million jobs lost since China’s shift fifteen years ago to largest importer to the WTO could conceivably return. Also, assuming the U.S. becomes much more aggressive in initiating disputes at the WTO, we would expect other countries to retaliate by bringing their own claims. Meanwhile, the boost to the domestic manufacturing sector should be minimal if these new trade policies trigger a further appreciation in the dollar.

Changes to U.S. fiscal policy are not expected to take effect this year, eliminating their potential boost to growth. The combination of proposed fiscal stimulus and higher trade barriers in 2018 will likely add to inflation expectations but this may be offset by changing technology, labor markets and unstoppable globalization.  American companies with large global footprints will suffer relative to domestically focused firms. We have positioned for this change by emphasizing small caps at the expense of large caps with our U.S. equity exposure. Small caps are traditionally domestically geared irrespective of their domicile. U.S. small caps face a potential additional benefit if the new administration follows through with promised corporate tax cuts.  Small caps would benefit disproportionately given that the effective tax rate of multinationals is already low.

 

3.  The Low Yield Environment Prevails

At its March 2017 meeting, the FOMC voted to raise the federal funds rate, the second increase since 2008’s financial crisis. However, the rise in government yields came to a halt after the FOMC talked back the future pace of hikes causing investors to scale back their expectations.

At the same time the continuing accommodative approach to monetary policy outside of the U.S. and the stronger U.S. dollar will likely lead to more foreign buying of U.S. Treasuries.  This would bid up prices and drive down yields, a headwind for the Fed.

 

4.  Monetary Policy

Historically, changes in real interest rate differentials have been the dominant driver of currency

movements in developed economies. In addition, growth in the dollar value of trade has been stronger, buoyed by higher commodity prices. Monetary policy expectations between the Fed and other G7 central banks should keep the US dollar strength in place.  A stronger dollar is both a blessing and a curse for margins. All else equal, it lowers the cost of imported goods and thereby boosts margins for import-intensive firms, while undermining profits earned overseas.

With 44% of S&P 500 revenues generated outside the U.S., the net impact of dollar strength is negative for overall corporate profits. Stronger growth is required to offset the negative impact on profits from a rising dollar.

 

With these themes in mind, we will continue to monitor economic data for traditional slow growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics.

Frame Global Asset Management considers these trends and factors them into our outlook for the economy in our twelve-month forward period. We look back to periods of similar economic behavior and use this information to predict the future behavior of the asset classes that we consider. Our investment process allows us to adapt for non-traditional monetary policy and other exogenous variables.

 

Deborah Frame, CFA, MBA

President and Chief Investment Officer

 

[1] Inflation measured by Consumer Price Index (CPI) is defined as the change in the prices of a basket of goods and services that are typically purchased by specific groups of households.

[2] Capital Economics. Non-farm payrolls rise 227,000 in January and 235,000 in February.

[3] FT.com. Morgan Stanley flags ‘record gap’ between hard and soft US economic data.

[4] The Economist. Why the Fed targets 2% inflation.

[5] Kiley, Michael T. and Roberts, John M. 2017. “Monetary Policy in a Low Interest Rate World.”  Brookings Papers on Economic Activity. BPEA Conference Drafts, March 23–24, 2017.

[6] Canaccord Genuity.  Canadian Focus List. April 4, 2017.

[7] Canaccord Genuity.  Canadian Focus List. April 4, 2017.

[8] OECD Harmonized Unemployment Rates. News Release: January 2017.  Paris, 9 March 2017.