- Interest rates are still encouraging growth, and the market may be underestimating the path of future rate hikes.
- While short-term rates may rise above long-term rates, creating an inverted yield curve, it may be premature as a sign of recession.
- It may be too soon for emerging market stocks to start to recover, relative to US stocks.
About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
A big part of my market-cycle work is based on the thesis that monetary policy should be judged not against some arbitrary rate of interest (like zero) but rather on where the policy rate is set relative to the natural (or neutral) interest rate, otherwise known as R-Star. R-Star is the theoretical rate of interest at which the economy is in equilibrium, i.e., growing at its full potential amid stable inflation.
This context in turn has implications for what effect an inverted yield curve (which could appear by 2020) might have on the business cycle. My thesis has been that, this time around, an inverted curve could pack less of a punch were it to occur when the Federal Reserve’s target rate is only at or modestly above the neutral rate. So, to me, the level and direction of R-Star is very important.
Conventional wisdom in recent years has been that R-Star has been flat-lining just above 0% after accounting for inflation and 2% nominal, which implies Fed policy has now approached the neutral zone (with a federal funds target rate of 1.75%–2.0%). This in turn suggests that, after 7 rate hikes, the Fed may not be all that far from the end of its tightening campaign, assuming the Fed’s goal is to go from a very accommodative to a somewhat restrictive monetary environment. Indeed, the federal funds forward curve has been signaling just that, pricing in just 3 more hikes by mid-2020 to a terminal funds rate of about 2.7%. This is well shy of the Fed’s dot plot,1 which suggests 6 more hikes through 2020.
So, it was a meaningful development for me when I noticed a few weeks ago that one particular measure of R-Star, the Federal Reserve’s Laubach-Williams 2-sided estimate2 (there are others), was revised meaningfully higher, from 0.05% to 0.86%. Now, instead of peaking at around 2.0% in 2007 and falling to around 0% in 2015 (and essentially flat-lining ever since), R-Star is shown as having fallen to 0.86% by 2015 and slowly climbing since (see chart).
Why should we care about a revision to a theoretical and backward-looking construct? Well, if R-Star is at 0% (real) and core PCE3 is 2%, then nominal R-Star is at 2%. That would mean the Fed funds target rate has effectively already reached neutral, implying that if the Fed intends to get to a moderately restrictive state, the forward curve has it basically right in pricing in just 3 more hikes over the next 2 years.
But if nominal R-Star is not at 2% but rather at 3% and rising, as one of the revised Laubach-Williams series now suggests, then that says to me the Fed has a lot more wood to chop just to get to neutral, let alone moderately restrictive.
I don't want to make too, too much of this, since after all R-Star is a theoretical construct that cannot be observed in real time. How much the Fed bases its monetary policy decisions on the level and direction of R-Star is something about which we can only speculate. My guess is that it's just one of many inputs.
Still, the difference between 0.05% and 0.86% amounts to about 3 rate hikes, which is not insignificant. What this suggests to me is that instead of being at neutral, the Fed may actually still be quite accommodative vis-à-vis the natural rate. That in turn could mean the Fed funds forward curve may be too complacent with the market's assumption of 3 hikes to 2.67% by mid-2020, and by extension that the Fed's dot plot has it more right than the forward curve. Indeed, since Labor Day weekend the 10-year Treasury yield curve already has jumped by more than 20 basis points. Who knows? There might be some upside risk to the dot plot come September or December if some members of the Federal Open Market Committee conclude that the economy is stronger than they had previously anticipated.
The above also suggests that financial conditions could tighten further and the dollar strengthen further. I think of it this way: For months now the market has been waiting for the proverbial light at the end of the tunnel in terms of the divergence in monetary policy between the US Federal Reserve and the rest of the world—especially the European Central Bank (ECB). The longer we wait, the closer the Fed will get to the end of its tightening campaign and the closer the ECB will get to the start of its. Now, that light at the end of the tunnel may be getting dimmer instead of brighter.
If financial conditions tighten and the dollar strengthens, that in turn suggests it may be too soon to bottom-fish in emerging-market (EM) waters. EM relies heavily on a falling dollar and easy liquidity conditions. I think investors may be overreacting here—EM is showing a year-to-date through September 15 performance gap of roughly 20 percentage points versus the United States—but, without a catalyst in the form of easier liquidity conditions, it’s hard for me to see a bottom.
It also suggests to me that valuation headwinds for equities in general could persist for some time, given that P/E (price-earnings) ratios generally move lower during periods when financial conditions are tightening, as they are now. With US year-over-year earnings growth peaking, US equities may see little upside from here.
My "glass-half-full" interpretation is that because the Fed may be a lot more accommodative than thought, even a Fed funds rate north of 3% would not be problematic for the US economy, whether or not Fed action results in an inverted 3m10y curve (where 3m10y is the difference between 3-month and 10-year Treasury yields). So, it adds to my conviction that a sell signal from an inverted curve in 2019 or 2020 would be premature. In my view it likewise follows that even if 10-year Treasuries go well into a 3-handle [3%], it likely won't kill the expansion.
The bottom line is that the Fed probably is further below neutral than even I thought it was.
Mind the other gap as well
The performance gap between the US and ex-US (especially EM) equities is unprecedented; by my count the US–EM differential is, as of September 15, at least 20 percentage points since the January peak in the global stock market. Relative performance is highly correlated to relative earnings growth of course, so it should come as no surprise that the year-over-year earnings gap between US and emerging markets also is huge, shifting from +11% to -13% (see chart).
Earnings and performance gaps between the US and EM economies are far from uncommon, but what is unusual (indeed, unprecedented) is the fact that this earnings gap is happening with US earnings growth (and economic activity in general) accelerating higher while the rest of the world is slowing down. From what I can see in the MSCI series, this is a first. Usually it's just a matter of all series moving directionally in tandem but EM moving more so than the United States.
So, is EM a buy? That's a tough one. The earnings and return gap usually resolves itself by EM recovering and, in the process, converging to US levels, so my guess is that this should happen in the coming months or quarters. My sense that China is probably at the nadir of its 2-year boom-bust cycle and now actively trying to reflate its economy corroborates this thinking. So, perhaps we are close to an inflection point.
But as I pointed out earlier, if financial conditions continue to tighten from here as the Federal Reserve continues to raise rates—perhaps longer than the consensus currently expects—then it’s hard to see a bullish catalyst developing over the short term. Back in 2016 when EM had a similar downturn, it was the Fed that came to the rescue by slowing down its tightening trajectory. Such an outcome seems much less likely this time around.
But even if EM does not recover in absolute terms, the relative performance gap could start to narrow in the coming months. In addition to the possibility of a recovery in China’s growth, it’s also plausible that some of the performance gap will narrow from the US side. As the top panel in the chart shows, PMIs generally move in the opposite direction of the Financial Conditions Index (FCI). Thus it is somewhat unusual for the US PMI to be making new cyclical highs while financial conditions are tightening. Clearly the US tax cuts have played an important role in that divergence. In a way, the country's tax cuts have rendered the US temporarily immune to the late cycle.
But signs have pointed to the growth rate for US earnings peaking at around 24% (year-over-year) and that next year’s growth could be back down to trend (around 7%). This suggests that the US economic and profit cycles may soon see a deceleration (but not a contraction), much like EM and the rest of the world is already experiencing.
Perhaps it will be a combination of China reflating at just the time the US slows, as positive effects of the tax cuts peter out. My hunch is that this could be a 2019 story. We'll be watching.
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