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It’s Official: The Fed Wants More Inflation – And It Cares About Jobs

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Last week’s Fed announcement was a major event. Its long-term impact should not be underestimated, even if the gist of the new inflation targeting framework unveiled (virtually) by Fed Chair Jay Powell at Jackson Hole was widely anticipated. Less commented on, but possibly even more important, was the other part of the new monetary framework – raising the importance of boosting employment, and noting its impact on inequality. In the past decade, monetary policy has been tightened in response to concerns about overheating labor markets even when there were no signs of imminent wage inflation. That’s no longer the Fed’s plan – and that matters. 

The Fed made clear its concern that a Japan-style disinflationary spiral could be a real danger if 2% is seen as a ceiling on inflation, given the zero bound constraint on its interest rate tools. The shift to average inflation targeting will instead allow inflation to overshoot the 2% goal in coming years to compensate for recent years of undershooting. It promises very low interest rates for years to come, and possibly higher inflation. Businesses, governments and consumers are invited to borrow and spend, while savers and investors may worry about where and how to seek returns. 

The shift towards tolerance of more inflation is notable for a central bank. But
Powell’s comment that it is “hard to overstate the benefits of a strong labor market” is even more remarkable to find in a Fed Chair’s speech. And it comes after passages on inclusivity, on narrowing the unemployment gap between white Americans and those of color, and on the notable gains of a thriving labor market for low and moderate income families in particular. This regime change acknowledges a shift in economic thinking that has been underway for some time as stagnant real wages for many middle income workers and rising inequality has troubled policy makers. The pandemic has only hastened the shift. In hindsight, the Fed’s move may look as significant as Paul Volcker’s determination 40 years ago to fight inflation, even if that sent interest rates – and unemployment – through the roof.

Observations and the takeaway for investors:
1. Change is afoot beyond the US

Since the Fed is – in practice and in times of stress – the central banker to the world, its moves have global implications. Dollar weakness makes it easier for other central banks to loosen policy. Indeed, unless they do so, their stronger currencies will tend to crimp exports and growth. Moreover, some major central banks may take comfort from the Fed change to ease their own outlook on inflation. None has the dual mandate of the Fed, that both requires and allows the focus on employment as well as inflation. But there is plenty of ammunition in the Fed’s analysis for the argument that price stability in the longer run requires continued creativity and bold action on the part of central bankers.  

Bank of England Governor Andrew Bailey, who startled markets earlier this summer with comments about reining in QE before raising rates, gave more context at the same Jackson Hole conference. He emphasized the importance of being ready to act with speed and at scale if instability threatened.

And as central bankers and finance officials grapple with policy adaptations to today’s low inflation and interest rate world, Japan will be important to watch. The sudden resignation for health reasons of Shinzo Abe, Japan’s longest serving post-war Prime Minister, temporarily halted a rise in equities on Friday.  It is true that the ruling party is in a strong position to achieve a smooth transition. And no one will openly reject Abenomics – the stated goal of boosting Japan’s economy out of disinflationary malaise and promoting growth. But some of those guiding economic policy, notably Finance Minister Taro Aso, have a more conservative view than the former prime minister, with a persistent focus on raising consumption tax to strengthen Japan’s finances. Japan’s experience shows that monetary policy alone cannot cure disinflation and promote a broad-based recovery. It will be good for Japan and for the world if Abe’s successor is a pragmatist who understands that. 


2. Central bankers still need governments to help out

For all the power of central bankers to affect financial markets, their tools don’t work well to boost broad-based growth. The call for fiscal policy help has only grown stronger as independent central banks have discovered limits to their power. In (inflationary) times past, central banks pressed for fiscal constraint to even out the costs across society of fighting inflation. Now they need help to achieve economic recovery. As Chairman Powell described it, the “key national goal [of strong labor markets] will require a range of policies in addition to supportive monetary policy.” On that front, governments have generally done better this year than during the Global Financial Crisis. But with US unemployment benefits tailing off this month and states and local governments cutting spending to balance their budgets, economists fear that recovery will falter.

3. This confounding year is not yet over

After some weeks spent in Europe, it is notable on return to see how uncertain the US outlook remains, with the economic data giving little guidance. Take July consumer spending. Markets were pleased that spending was up compared to expectations.  But the rise in July was smaller than those in May and June, as new Coronavirus infections surged and pandemic fears climbed.  New daily infections are down from July and, importantly, the danger of dying from the virus is still decidedly less than in its early days. But Americans are still getting infected and dying at worryingly high rates, while outbreaks and hot spots continue to occur in Europe and Asia, leading to shifting regulations around movement and activity. 

Better than feared data for corporate earnings have helped equities to reach new highs – layered on top of the unprecedented Fed actions. But with new jobless claims going above 1 million again in mid-August, and a drip of corporate layoff announcements, we are a long way from the strong labor market that Chair Powell extolled – and Americans need. 

We know that the third quarter GDP will look good – the economy has improved from the dreadful second quarter. Markets will be looking beyond that, to the end of the year and next.


4. Markets continue to rise

Investors had a number of areas to focus on this week as the Fed, global equity markets and geopolitical tensions continued to post headlines and factor into portfolio decisions.

U.S. equity markets rallied for a fifth consecutive week as stronger than expected corporate earnings along with the Fed continued to sustain positive investor sentiment. Meanwhile Chinese equity markets encountered volatility while the rest of emerging markets earnings, GDP forecasts, and currency moves were top of mind. Japan had a notable announcement and a rally in the Euro was one of many signs for optimism in European markets.

Federal Reserve and US Monetary Policy. Federal Reserve Chair Powell’s speech at the virtual Jackson Hole conference was highly anticipated by investors for takeaways from the Fed’s monetary policy review. Most investors were focused on the Committee’s expectation that rates will be lower for longer. While short-term market impact from the formal policy change has been muted, the long-term consequence could be substantial if the Fed is successful in spurring inflation. The FOMC has signaled at past meetings that they are willing to allow inflation to run above 2%, and bonds have reacted accordingly as breakeven inflation rates have been on a steady ascent with 10-year breakevens climbing from 0.5% on March 19th to 1.73% on Thursday – and with Thursday’s action largely priced in, the breakevens only ticked up +1 bps on the news. The question going forward is whether monetary policy will be able to create the inflationary forces the FOMC seeks or will that ultimately be in the hands of government policymakers and fiscal policy. At this point, the market – as reflected by breakeven rates – is indicating that they have little faith in the former.  

Most portfolios don’t seem to be positioned for the Fed to succeed and are not prepared for an inflation shock. The inflation experience of the last quarter century has been so muted that investors believe economic growth to be the only driver of asset prices, forgetting that inflation can as well. While real asset investments have been a drag on portfolios for a long time, now is likely not the time to throw in the towel on this asset class. Changing trends in office, housing/apartments, storage, and logistics are not to be missed.

Developed Markets Continue to Rise. Developed market equities continued to move higher last week amid persistent strength among the software, technology, and communications sectors. Speculation is that Softbank may be gaining technology exposure through call options as a substitute for immediately deploying capital. In fact, data on put/call ratios from the CBOE is showing an unusually high number of outstanding call options on single names. Apparently, Salesforce.com’s surprisingly strong earnings report last Tuesday night created a massive move across the sector leaving trading desks scrambling to reduce gamma and reduce their exposures.

Appetite for high current-multiple growth seems to be waning across the investment community. Some of the more frothy segments of the market are showing signs of reversal and investor demand for more cyclical financial and industrial stocks has improved on the margin.

Europe started the week strong but trailed off a bit as this year’s outperformers in technology and health care started to see selling. According to recent announcements, earnings in Europe for Q2 have surprised 8% to the upside on a cap-weighted and 6% on an equal-weighted basis. However, the bar was quite low and corporate earnings still fell by 65% and revenues fell by 25% year-over-year for the quarter. Meanwhile, data showed German consumer morale worsened heading into September and the recent pickup in Coronavirus cases threatens to mute the building optimism we’ve seen over the last several weeks. The EU Recovery Fund continues to counter headwinds from the virus and European equities have benefited from the Fund’s potential positive impact on the macro outlook in the coming years.

The bigger news in developed markets this week was in Japan. The drop in equities after Abe’s resignation opened a potential buying opportunity. 

Chinese Markets. Despite a number of negative headlines and news, volatile Chinese markets ended higher this week with the CSI 300 Index gaining close to 3% and the Hang Seng Index gaining over 1%. Positive forces included China’s July Industrial Profit data, which showed growth for a third straight month at +19.6% year-over-year following an 11.5% increase in June – reflecting a consistent recovery in the Chinese economy according to these numbers. While there may be less confidence in actual numbers the direction remained positive. Sentiment was further lifted with strong company earnings reports, especially across consumer and medical sectors. Perhaps signaling a reduction in tensions, US and China both reaffirmed their commitment to the phase-1 trade deal. China has begun to show some signs of flexibility in its ongoing tensions with the U.S. Overnight, the vice-chairman of CSRC proposed to allow US regulators and audit firms to conduct reviews on SOE companies as a trial. Similarly, the CBIRC approved Blackrock and Temasek to set up wealth management JVs in Shanghai in a move to further open up the financial industry to foreign institutions. For investors focused on Chinese opportunities the Ant Financial Group IPO filing was another milestone. Rumored to be seeking to raise $30 billion, it may be another record breaking IPO. If Ant is able to raise $30 billion it would become the largest IPO in history. Alibaba, which has a 33% stake in Ant, raised a record $25 billion when it debuted on Wall Street in 2014. That number has only been surpassed by Saudi Aramco, which raised $29.4 billion in its Riyadh IPO in December 2019, just before the dramatic fall in energy prices after 2019.

Emerging Market Trends. Elsewhere in emerging markets we are seeing earnings and GDP exhibiting divergent trends. Lower potential GDP growth as fiscal stimuli expire is a concern for investors and a weaker than expected global recovery along with potential further deterioration of the US-China conflict are also top of mind. Counteracting these downside pressures are the weaker USD which historically has been associated with stronger emerging market equities. Over the past 20 years, every time the USD weakened by at least 5%, EM equities gained a median return of 19%. The best performing EM markets during periods of USD weakness tend to be twin-deficit countries such as Turkey, Indonesia, and Brazil. From a sector perspective, industrials, materials, and financials also historically tend to outperform.

While we are cautious on Turkish assets as structural issues may persist for some time, the opportunities in Indonesia and Brazil are attractive. Both countries have seen their currencies depreciate significantly this year and are well positioned to benefit from an uptick in commodity demand, particularly in mining and agriculture. Indeed, China has been particularly active in securing mineral and land rights in both countries, diversifying away from traditional partners, Australia and the US. Brazil’s January to April 2020 exports of soybeans to China, for example, were 906 million bushels. For reference, that’s more than all US soybean exports to China since February 2019. The recent floods in China have made food security an even more critical issue for President Xi and his inner circle. Well-endowed emerging market countries with a hunger for dollars are an appetizing alternative. 

Where to go from here? Globally, there seems to be unabated risk appetite by investors searching for yield in a market that is disconnected from economic realities, growing inequalities and the effects of a pandemic. Equity markets churn higher even if there are momentary pullbacks, shrugging off geopolitical tensions or future instability. The latest data indicates that hedge funds have started to reduce exposure to secular growth and position for a cyclical recovery. Investing in sectors such as financials has started to increase, a telling signal of sentiment as financial stocks are some of the first winners coming out of an economic slowdown. We do remain concerned about the financial exposure to consumer debt. Despite potential US regulations on holding Chinese equities, US institutional investors are increasingly looking to gain exposure to China and emerging markets more broadly. In China our investments remain mainly in areas related to domestic growth and not exports. At this juncture more than ever – with a US election forthcoming and an unknown Coronavirus path – we believe investors should tread lightly and cautiously with any drastic changes to portfolio positioning. While, of course, always factoring in the ever-present tailwind of the Fed.  
 
RockCreek Update
The RockCreek team continues to work seamlessly and efficiently remotely, and some team members have started working from our offices with careful planning. We maintain a strong sense of community with morning coffees, virtual town halls, meditation with The Meditation Foundation, guest speakers and more. The RockCreek book club continues to stay active: our readers recently finished Annie Duke’s Thinking in Bets: Making Smarter Decisions When You Don’t Have All the Facts and are now starting Phil Jackson’s Eleven Rings: The Soul of Success. 

RockCreek continues to support local communities and small businesses throughout the pandemic. We believe this is even more important moving forward as many Federal programs are coming to an end or at least pause. We are eager to learn of more opportunities to invest in inclusive growth during this crisis. Please let us know if you are aware of any opportunities in which we can get involved.

Team RockCreek
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