Investment Strategy Insights: What to Expect from a Powell Fed

Author:
Michael J. Kelly, CFA
Global Head of Multi-Asset
New York

6 November 2017

The Federal Reserve chair, despite being appointed by the president and overseen by Congress, leads a politically independent decision-making committee composed of the seven members of the Board of Governors (including the chair) and five rotating Federal Reserve Bank presidents. Although only custom restrains the Federal Open Market Committee from overriding its leader, effective chairs have been sufficiently persuasive to forge consensus among the committee’s independent-minded members. At pivotal moments in the past, for example, strong-willed chairs such as Paul Volcker, who set out to break inflation, and Ben Bernanke, who faced a once-in-70-years financial crisis, turned the heads of resistant committee members. That will be no small feat for incoming Fed Chair Jerome Powell, considering that the committee is stacked with ideologically committed economists holding PhDs and Powell will be the first-ever chair from outside the economics profession. As such, we expect Powell to seek consensus to a greater extent than his predecessors. And during the upcoming four-year term, when post-crisis monetary policy must be surgically and carefully withdrawn without surprising or spooking the markets, consensus-based decision-making may be just what’s needed.

During her reign, Chair Yellen often was supported by dovish governors with occasional pushback from the more hawkish Federal Reserve presidents. With four governor seats yet to be filled, the committee’s increasingly important ideological composition is hard to handicap. During the run up to Powell’s nomination, four candidates were floated to test the market’s reaction. Only the trial balloon of John Taylor’s name invoked a bump up in interest rates with a strengthening of the US dollar. If a bubble buster lurked among the candidates, it was most likely Taylor, said the markets. Muted reactions to the other candidates presaged what eventually transpired, which was no discernible market impact upon the formal announcement of Jerome Powell as Fed chair. His term begins March 1.

Historically, except for the selection of Paul Volcker, the fatefulness of the choice of Fed chair is only apparent in hindsight. But given Powell’s background as a former attorney and private equity executive, and with Randal Quarles as vice chair of regulation, the next chair’s four-year term may turn out to be particularly impactful on the regulatory front. Prior chairs were thought to be too focused on economics, and not enough on the Federal Reserve’s regulatory responsibilities.

Meanwhile, the equity market is more focused on reflation and the prospects for US tax reform. Bond and currency markets remain more focused on a prospective December rate hike and the onset of balance sheet run off. Overseas, market participants are more focused on whether Haruhiko Kuroda will be reappointed to head the Bank of Japan and who will be named to lead the People’s Bank of China.

  • INVESTMENT VIEWS & CONVICTION SCORE (CS)

    Investment team views on how portfolios should be positioned for the next six to nine months.
    1 = Bullish 5 = Bearish
    Change from prior month is indicated in parentheses.

Economy CS 2.25 (unchanged)

Markus Schomer, CFA, Chief Economist, Global Economic Strategy
We kept our score at a marginally bullish 2.25 due to many US economic indicators having held up despite the negative effects of Hurricanes Irma and Harvey, and developed world growth running at a brisk pace. Citi’s Economic Surprise Index for the US, eurozone, Japan, and the UK, for instance, is in positive territory for the first time in seven months. The IMF ostensibly agreed with this better backdrop and upgraded its 2017 and 2018 growth expectations in its October World Economic Outlook, although it highlighted one of many near-term headwinds: rising geopolitical risks. NAFTA negotiations, for example, have not progressed and may result in a US exit. In addition, many developed-world central banks seem likely to embrace tighter monetary policies in the near term.

Asia Economy CS 2.50 (unchanged)

Paul Hsiao, Economist, Global Economic Strategy
Our score remains marginally bullish at 2.50. A quarter-end upturn in China, continued cyclical improvement in Japan, and robust September exports from many countries underpin a solid macroeconomic environment that should propel Asia’s growth to a 7.5% annual rate in the second half from 5.9% in the first. Still, President Xi’s optimistic opening remarks at China’s 19th Congress of the Communist Party has not changed our base case of a slowing China over the next few years. Headline 2018 GDP growth likely will be dragged down by a deceleration in the property sector and capacity reduction due to environmental policies. There also is downside risk to regional growth if India does not rebound quickly from its prior implementation of the Goods and Services Tax (GST).

Rates CS 3.00 (unchanged)

Roberto Coronado, Senior Portfolio Manager, Developed Markets Investment Grade
Since the end of March, 10-year US Treasuries have traded in a 2.10% to 2.40% range despite a “hawkish” Fed and the potential for tax reform. US core inflation below 2% since the end of Q1 continues to disappoint markets as do broad-based signs of weakness, even if some prove transitory. Given other G4 rates, we expect strong technical support for US Treasuries to continue. The Fed’s slow start on balance sheet reduction shouldn’t have any material effect on levels. And since the ECB has prepared markets for the reduction of its QE program, we don’t expect a Bund sell-off in the near term.

Credit CS 3.50 (unchanged)

Steven Oh, CFA, Global Head of Credit and Fixed Income
Spreads remained range bound with a favorable fundamental outlook offset by tight valuations. The fourth quarter could see rate-induced credit market volatility as key central banks issue policy guidance that may alter expectations for 2018. While nothing on the near-term horizon materially threatens current benign market conditions, markets have fully priced in the calm, so we favor maintaining the current defensive posture. In leveraged finance, we continue to prefer loans over high-yield (HY) bonds, and find euro and sterling loans to have the best value. We prefer US HY over Europe. In collateralized loan obligations, fundamentals support a shift to investment grades (IG), but we think the current technical demand for HY results in a short-term value opportunity in single-Bs. IG spreads have retraced post–crisis tights, but given our defensive bias we remain neutral versus leveraged finance. With strong emerging market (EM) performance YTD and lack of premium over developed markets, we maintain our defensive IG bias to EM, but favor US over EM.

Currency (USD Perspective) CS 2.75 (unchanged)

Natasha Smirnova, Portfolio Manager, Global Emerging Markets Fixed Income
After September’s FOMC statement that portrayed the economy’s persistent undershooting of inflation as temporary and highlighted the potential for a Fed rate path more hawkish than markets previously anticipated, the US dollar has been confined to a narrow range. The dollar’s underlying trend remains negative based on reduced hopes for US tax reform, elusive US inflation (which may be a global phenomenon), and a downward trend in the UST/Bunds yield differential despite current widening, which is just a correction. Look for central bank behavior and inflation to remain the main drivers of world currencies, and for EM foreign exchange (FX) to rise on a pickup in EM growth.

EM Fixed Income

USD EM (Sovereign and Corp.) CS 3.25 (unchanged)

Local Markets (Sovereign) CS 2.75 (unchanged)

Steve Cook, Senior Portfolio Manager, Co-Head of Global Emerging Markets Fixed Income
In its October World Economic Outlook, the IMF shared our view of likely moderate global growth and low inflation. Despite a possible minor slowdown in China, EM growth has been picking up in recent months, and we remain optimistic on China’s growth overall. Gradually improving fundamentals, catching up with fairly tight EM spreads, leave technical factors and external risks to drive EM debt. The Fed-driven September wobble has been replaced by new demand for yield and EM currencies should benefit from the improving EM growth outlook, supporting our EM FX optimism.

Multi-Asset CS 2.20 (-0.20)

Agam Sharma, Portfolio Manager, Multi-Asset
With the shift to reflation, we favor growth assets in the intermediate term. We expect the rise in consumer and business confidence that started last year to translate into an early-cycle reflation of volumes, with stepped-up consumption and greater capital expenditures. This should continue to broaden, fortifying earnings growth and accelerating cash flows. Concurrently, the modest trimming of expansionary monetary policies that DM central banks are considering means the global savings glut and excess central bank liquidity likely will dissipate more slowly than the rise in global EBITDA, which is bullish for discounting cash flows. We have nudged up our score modestly to 2.2. We continue to favor select growth assets and floating rate instruments over credit and duration. Specifically, within DM equites, we favor select US financials, small caps, and value; Japan remains attractive. In EM, we are watching changing fundamentals in Indonesia and India equities, particularly around the impact of GST reform. Tech sub-sectors are likely to benefit from rising corporate capex, leading us favor productivity-enhancing technology.

Global Equity CS 2.75 (unchanged)

Lizette St. Hilaire, CFA, Research Analyst, Global Equities
With markets strong in the wake of Q2 results and expectations high going into Q3, concerns grow over valuations. Upward revisions in earnings forecasts, however, may give investors just what they are looking for to maintain share price momentum. Still, high historical valuations mean greater selectivity is required. Looking into 2018 and beyond we continue to be cautiously optimistic given improving demand trends and more positive corporate sentiment.

Global Emerging Markets Equity CS 2.50 (unchanged)

Andrew Jones, CFA, Portfolio Manager and Head of Equity Research, Global Equities
Flows to EM equities continued in September, and we await 3Q earnings to confirm the year’s positive trend. Since expectations have risen for the highest quality EM companies, we are watching smaller companies that also enjoy improved fundamentals but have been overlooked. Evidence is mounting that China’s non-performing loan problem will not lead to a crisis at worst, and at best could be successfully resolved without broad economic harm. Brazilian inflation continues to trend down, helping businesses and consumers recover as rates decline. We remain constructive on EM market equities given macro and micro fundamental improvements. We believe selection will be increasingly important given low pairwise correlations in Asia and across EM broadly.

Quantitative Research

Haibo Chen, Portfolio Manager and Head of Fixed Income Quantitative Strategies
Our US Market Cycle Indicator (MCI) improved slightly as the curve steepened and the BBB credit spread tightened. In corporate credit, IG and HY remained expensive. While our EM credit forecast remains attractive, our DM credit forecast turned negative. Among sectors, we favored basic industry, banking, and transportation over natural gas, communications, and consumer non-cyclicals. On rates, we expected yield levels to increase in the UK and Europe and decrease in the US. We expect the yield slope to flatten globally except in Japan, where we expect it to remain unchanged. We expect curvature to increase in Europe and the UK, but decrease in the US.