OCBC Wealth Management

2018
As expected, in a unanimous decision, the Federal Open Market Committee (FOMC) raised interest rates by another quarter percentage point to the 2 to 2.25% range – its third hike this year and the eighth increase of this cycle. Perhaps the most striking change of this most uneventful meeting was the removal of previous assurances that policy was still “accommodative”.

Removing the reference to accommodative policy implicitly acknowledges that interest rates are not far from neutral. One can think about the “neutral rate” as the “goldilocks” interest rate that keeps the economy operating on an even keel. It’s neither too low that it would boost economic activity nor is it too high that it would restrain growth. Yet, this neutral rate is not directly observable and thus not precisely measured. It is purely an estimate and its range can be broad. The FOMC estimates the neutral rate to fall within the 2.5 to 3% range. Hence, another 25 basis points hike in December this year will push the fed funds rate into neutral territory.

Given the type of ambiguity inherent in estimating this rate, the decision to drop the reference to policy accommodation could underscore the transition to a more uncertain environment for monetary policy. Flexibility will be necessary when navigating through such an uncertain environment. Hence, unshackling themselves from such definitive statements provide some degree of freedom with which to calibrate the pace of interest rate increases over the next couple of years, contingent again on how economic variables evolve and forecasts change. Ideally, the Fed would like to prolong this period of positive growth without unnecessarily tipping the economy into a recession as a result of policy mistakes.

Rising interest rates in the US is also being accompanied by a shrinking balance sheet. The Fed ended quantitative easing in 2014 and began the process of winding down its balance sheet (termed quantitative tightening) in October last year. The policy has continued to operate on auto-pilot in the background, with the Fed gradually stepping up the pace of withdrawal. This will reach the maximum velocity of US$50 billion per month from October this year.

The pursuit of policy tightening comes at a period when growth is undeniably strong and labour markets are unambiguously tight. Aggregate economic activity remains robust with Purchasing Manager Indices (PMIs) firmly in expansionary territory and GDP growth largely above potential – all this despite the spectre of Trump’s trade war hanging over the macro environment.

Inflation risks remain relatively benign with the Fed’s favourite core Personal Consumption Expenditure (PCE) inflation touching its 2% target (see Chart 2). Wage growth has been tepid, but recent indicators show a more pronounced upward trend. Labour market sentiments are firmly positive as well, with quit rates hovering at record highs (see Chart 3). Wage pressures will no doubt feed into inflation, but this will likely be a slow-moving change, as evidenced by the experience of the past few years.

2019
Looking ahead to 2019, the Trump administration’s fiscal stimulus should continue to support growth, even if the din of trade tensions breed uncertainty. Inflation will continue to find support from a tight labour market and Trump’s demand stimulus. Given such dynamics, the next perhaps 2 rate hikes are more or less straight forward decisions.

It is when the juice of fiscal expansion has run out that the economic outlook becomes particularly uncertain. The effects of Trump’s fiscal stimulus may fade further into 2019. If such strong growth is indeed self-sustaining and core inflation accelerates, in part due to trade tariffs, the Fed may be forced to become more aggressive than what they let on to be, meaning that the US central bank would have push interest rates faster and higher than expected.

Meanwhile, if growth falters and inflation does not pick up materially, then the Fed could pause hiking interest rates altogether. A flat yield curve would make this a prudent move. Both these scenarios – runaway inflation in the first and possible recession in the second – could be problematic for markets.

We take a more middle ground in our forecasts. We expect a moderate slowdown in growth into 2019 with a gradual pick up in core inflation, which would support the Fed’s current pace of one hike per quarter through the end of 2019. Hence, we see 4 rate hikes in 2019.

Admittedly, geo-politics tend to complicate economics. We would be more confident that the third scenario plays out insofar as we observe trade tensions simmer down and geopolitical stability return in 2019. Sure, the latest round of 10 to 25% tariffs on $200 billion worth of Chinese imports may not have a material impact on the US$20 trillion US economy, but one should not underestimate the potential for escalation when abrasive and confrontational heads steer the wheels of national policy.

Should the politics of trade worsen to a degree that growth slows down significantly, and inflation spikes due to tariffs, the Fed may have a difficult choice ahead. As it is, the US government’s finances are stretched following the Trump administration’s fiscal expansion, limiting the use of fiscal policy as a countercyclical measure. The Fed may find itself, once again, the only game in town.

2020
It’s difficult to predict with any amount of clarity and/or accuracy what 2020 has in store. US recession risk is plausible, especially if fiscal policy reverses or fiscal tightening takes hold as the government would need to rein in spending somehow given the worsening budget deficit position. As mentioned earlier, a sharp escalation or broad worsening of trade conflict could bring forward recession risks. At this stage, this is far less clear. Positioning for more rate hikes ahead

We are now nearing the start of the tightening phase of the monetary policy cycle where interest rates are assuredly heading higher, at least for the foreseeable future. Yet, we believe there is still scope to be generally constructive on equities even as interest rates rise.

Quite clearly, the Fed is increasing interest rates for good reasons – US growth is strong, inflation is finally on target and the labour market is at full employment. Robust demandside activity, healthy economic growth and strong earnings provide valid reasons to remain fairly constructive on stocks.

At the same time, interest rates are not at levels that will drag down growth and corporate earnings. The Bloomberg financial conditions index for the US remains loose despite rising interest rates, which provide some indication that the current interest rate environment remains accommodative for risk assets. Interest rates will only start to bite once the Fed breaches the neutral rate. By the Fed’s own estimations, this may only be a concern some time in mid-2019 or later. We still have time.