Market Update (March 2019)
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The US economy appears to have slowed further in the early months of 2019 after a sharp downturn in the last quarter of 2018. With inflation slipping back below the Fed’s target, markets are now pricing in no change to the Fed funds rate this year and the prospect of a cut in 2020. The Fed’s ‘patient’ approach to policy, seemingly a 180-degree turnaround from its position late last year, now seems totally justified.
While much attention has been given to the near-term outlook for Fed policy, there has been a lively debate regarding the monetary policy framework for the longer term. In a recent speech, Fed Vice Chair Richard Clarida echoed Jerome Powell’s comment that now was a good time to undertake a reassessment of the monetary policy framework given the economy was “operating at or close to our maximumemployment and price-stability goals.”
According to Clarida, a range of factors suggest that low interest rates will “persist for years”, including an ageing population, lower working age population growth, and diminishing risk appetite. This means the Fed would likely run up against the socalled zero lower bound when combating the next recession. Offsetting a significant deflationary shock when the current and ‘neutral’ Fed funds rate is already very low could prove difficult and may result in permanently lower inflation expectations, similar to the Japanese experience.
Although the Fed would not change its current 2% inflation target, it could introduce a strategy that seeks to make up for periods of below-target inflation with periods of above-target price rises. In other words, the Fed would target average inflation over the cycle of 2%, as opposed to an upper limit of 2%.
Meanwhile the ECB sharply cut its expectations for growth to 1.1% in 2019 from 1.7% and to 1.6% in 2020 from 1.7%. The ECB president Mario Draghi referred to weak data from the manufacturing sector arising from a slowdown in international demand and specific factors including Brexit, problems in the car industry and the US-China trade dispute. Reflecting the more dovish turn in central bank policy, the ECB made a fresh offer of cheap funding for the zone’s banks and reinforced its expectation that interest rates would be unchanged “at least through the summer of 2019”.
The Chinese equity market has been one of the best performers this year after being among the worst in 2018. The decision by index provider MSCI to widen the inclusion of domestic Chinese stocks has helped, while signs of progression on trade talks with the US and evidence of stimulatory policy measures have also buoyed the market. Chinese equities, through Hong Kong listed and other offshore listed securities, currently have a 31% weighting in the MSCI Emerging Markets index. The decision to widen inclusion for domestic shares is expected to take the weighting to 34% by late 2019, resulting in flows of at least US $100 billion, according to some analysts. Perhaps the most significant data release for China was the January total social financing data, which showed a surge in overall credit, reflecting the stimulus measures put in place by the Chinese government.
In Australia, economic growth slowed sharply in the second half of 2018. With core inflation remaining below target, the shift in RBA policy bias from tightening to neutral seems totally justified. Indeed, the extent of the slowdown and the evidence for 2019 to date would suggest that the RBA could well ease policy at some stage during 2019. Some observers are suggesting the 27-year-old expansion is about to end and has in a sense become a victim of its own success, given that confidence in the expansion has been accompanied by a large build-up in household debt.
Source: Lonsec Investment Outlook Report (March 2019)