- Robust global growth, modest inflation and the introduction of fiscal stimulus have increased the Fed's inclination to hike rates at a faster pace than what the market is pricing. Risk assets have been digesting the steep rise in interest rates and, year-to-date, this has meant elevated volatility and more modest returns
- Looking further out, late-cycle dynamics will likely become more pronounced by 2020, when the Fed will have hiked sufficiently above its estimation of the neutral rate and when today’s fiscal tailwind turns into a headwind
- We expect a further increase in front-end U.S. rates and thus a further flattening of the yield curve. In credit, we continue to prefer floating rates, as well as short-term fixed rates
- We think equity markets will recover and climb higher in the back half of this year, as near-term growth prospects still look solid
- At the sector level, we continue to favor the broad tech sector (where the growth profile is more secular than cyclical), and to a lesser extent financials and healthcare
We argued back in September that the rates market was failing to appreciate the Fed’s willingness to continue hiking its policy rate. Remember the context: There was an unexpected drop in inflation last year, driven in large part by a one-off collapse in wireless communication prices, leading to market skepticism. Fast forward to today, we have seen a meaningful repricing of the Fed, combined with a rebound in core inflation. In addition, global economic activity has accelerated and forecasts have been upgraded (see charts below). This is key. Remember that it was global growth concerns, and the associated collapse in commodity prices and dollar strength, back in 2015/2016 that prevented the Fed from hiking at its intended quarterly pace.
So where do we go from here? Admittedly, predicting the precise number of times the Fed will hike this year and next is very difficult, but more qualitatively, we can say with high confidence that the Fed is not going to stop hiking and that the market still is not fully prepared for it beyond this year (see chart below).
True, the Fed does not have accelerating inflation to justify continuing to hike (see charts below). We argued back in February that accelerating inflation is unlikely to become a problem, given heavy secular drags. But inflation right now is beside the point: We believe the Fed just wants to get its policy rate back to what it thinks is a “neutral level,” and it thinks the tight labor market (with the unemployment rate now in the 3% zone) justifies continuing to hike and perhaps even matters more than undershooting on inflation. The old adage “do not fight the Fed” seems relevant.
The neutral fed funds rate is the rate at which monetary policy is neither stimulative nor restrictive. This rate is unobserved, but the Fed thinks it is currently around 3%. The beauty of the neutral rate construct is that it can help frame how the economy, and ultimately markets, may respond going forward. To us, there are three possible scenarios through the rest of this year and next:
- Fed Policy Mistake—The neutral rate is materially lower than the Fed thinks, and the Fed may have already crossed it or is on the cusp of crossing it. Some private estimates of the neutral rate put it as low as 1.5%—2%. In this scenario, the Fed is embarking on a policy mistake by hiking too quickly. The material flattening of the yield curve that we have witnessed since September could be consistent with this view.
- Base Case—The neutral rate is around the 3% where the Fed thinks it is, and the Fed will not get back to that level until the middle of next year at the earliest. In this scenario, the growth indicators, especially the labor market, should hold up through the rest of this year and next, although the Fed may overshoot the neutral rate, commanding a growth slowdown in 2020 or 2021. At the end of the cycle, the Fed typically overshoots its perceived neutral rate out of fear that the labor market may be getting too hot. In fact, an overshoot is already depicted in the Fed’s dots, which show the policy rate getting to nearly 3.5% by the end of 2020.
- Productivity/Capex Boom—We are on the cusp of a productivity boom that lifts the neutral rate to well above 3%, allowing the Fed to hike much more than anyone thought, and the economic cycle to extend well beyond 2020/2021.Proponents of this view often point to last year’s corporate tax cuts as the catalyst to an investment boom.
Not surprisingly, the Base Case scenario seems the most likely to us. In this sense, we agree with the Fed on its assessment of the neutral rate. The trouble for investors is that the scenario that is most accommodative for markets, the Productivity/Capex Boom scenario, to us seems the least likely. To be sure, Q1 earnings reports showed strong double-digit, year-over-year growth in capex, but much of this increase was based off orders placed in 2017. Since then, the leading indicators on capex spending suggest growth has moderated (see chart below). We suspect that a large portion of the pickup in capex last year was driven by inventory restocking on the back of material inventory drawdowns in 2015/16. In addition, we are still not seeing any signs of a pickup in economy-wide productivity growth.
More generally, we do not believe that last year’s corporate tax cuts will lead to a surge in capex and productivity comparable to the 1990s boom. True, the survey-based sentiment indicators on capex intentions still look encouraging (see chart above), but we would note that in the past these indicators failed to predict actual capex. One example would be in the immediate years after the 1986 Reagan tax cuts (see charts below). We are open to the idea, which some analysts argue, that the Reagan ‘86 tax cuts facilitated the 1990s capex boom. The problem with this interpretation, from a markets perspective, is that you first needed the 1990—91 savings and loan recession to clear the path for better capex visibility.
Thus, the challenge embedded in the Base Case is that there is arguably a disconnect between markets and the economy. In this view, the recession will not come until 2020 at the earliest, and even then we do not see more than a 50% chance. But markets are future-extrapolating machines, and they are currently looking forward and seeing a potential Fed policy rate that is materially higher than what the forwards are pricing, in conjunction with a possible growth deceleration in the coming years driven by the Fed hiking above the neutral rate (not to mention an eventual headwind from today’s fiscal policy tailwind). To us, a more active Fed seems like an essential reason why the equity market is not responding more favorably to better-than-expected Q1 earnings. Other risk factors include trade tensions between the U.S. and China, uncertainty surrounding geopolitics, and concerns that global growth may have peaked and could continue to decelerate meaningfully (a view to which we do not subscribe).
To be sure, we do think markets will recover and climb higher in the back half of this year, as near-term growth prospects still look solid. But the issue of the Fed, the neutral rate and an eventual growth slowdown is not going away. While there is historical precedent for late-cycle buoyancy in risk assets, and we remain comfortable with some degree of optimism now, we are incrementally more cautious looking further out.
Chief Markets Economist, J.P. Morgan Private Bank
Capital Markets Economist, J.P. Morgan Private Bank
Capital Markets Economist, J.P. Morgan Private Bank
Associate Markets Economist, J.P. Morgan Private Bank
BEA— Bureau of Economic Analysis
BLS— Bureau of Labor Statistics
Capex— Capital Expenditures
CPI— Consumer Price Index
Fed— Federal Reserve Bank
FRBCLE— Federal Reserve Bank of Cleveland
GDP— Gross Domestic Product
IMF— International Monetary Fund