With policy uncertainty likely to decline going forward, and with more confirmation in the economic data that the global cycle is bottoming out after its summer soft patch, the outlook for risky assets brightened further over the week. The recent sideways move in most of them therefore might well turn up again over the coming months. We therefore broadened our risk-on stance by upgrading real estate to a medium overweight and adding fixed income spread products as a small overweight, next to equities.
Policy uncertainty index may have peaked in October
More clarity from the Fed
Markets have started to sail sideways as new hope for quantitative easing (QE) in Europe and a less foggy outlook for US monetary policy seem to have reduced investor’s fears of stormy weather to come. After markets were pushed up by the European Central Bank (ECB)’s unexpectedly strong hints of an expansion of its QE program, they easily digested the much more hawkish remarks coming from the US Federal Reserve last week. While the Fed statement did cause bond yields to rise modestly and the US dollar to strengthen somewhat, it also helped clarify the future path of global monetary policy settings. The improvement in visibility was probably a positive force for risky assets, one that largely offset the headwinds stemming from the Fed’s less dovish stance.
Just like news about the state of the economy or the direction of policy mix, the amount of uncertainty that investors perceive around their base-case outlooks plays an important role in determining their risk appetites. An improving outlook and falling uncertainty are the best recipe for “risk-on” markets, but other combinations can lead to mixed results in terms of market behaviour. The latest ECB news in combination with the latest earnings/economic data scored positive on both metrics, and lifted markets. The latest Fed signals weighed a bit on the outlook, but they also reduced uncertainty and therefore had no clear directional impact on risky assets, even while impacting bond and currency markets.
In the past year policy uncertainty has grown steadily, not only as a result of the end of QE by the Fed and the beginning of QE in Europe, but also due to a shift in the Chinese currency regime, a renewed political crisis in Greece, a Scottish independence referendum, tighter trade sanctions on Russia, looser ones on Iran and important elections in Brazil and Turkey. Against that background, it now seems that the policy outlook might become a bit more transparent towards year-end. The graph shows economic policy uncertainty in the US and Europe, as measured by such factors as newspaper coverage and disagreement among economic forecasters. It illustrates the recent rise in policy uncertainty and also hints at signs of peaking in October. Looking at the graph’s previous peaks, it appears that barring events such as a major terrorist attack (2001), engagement of US or NATO troops into war (2003), a new credit or Euro crisis (2008, 2010-13), policy uncertainty is unlikely to rise much higher from here.
Fed clearly intent on December hike
The Fed’s latest comments have increased our confidence in the base case of a December rate hike. Its description of the domestic economy remains relatively upbeat, with consumption and capital investment “increasing at solid rates”. And despite a slowdown in the pace of job growth in previous months, the Fed believes that the labour market is still on a tightening trend – a view that was reinforced by last Friday’s October payroll report, which surpassed the consensus view in nearly all respects. With its statement, which explicitly mentioned the possibility of hiking at the next meeting, the Fed could hardly have made it any more clear that it still has its mind firmly set on a December rate hike, subject to the usual data dependency. External developments or domestic data weakness could still push the Fed away from its hiking intention. But at the very least the Fed wanted to put markets on alert so that a December rate hike, if it happens, will not be a big surprise.
Risk of postponement
One of the main risks of postponement relates to expectations that Fed tightening may act as a trigger for further emerging market (EM) weakness and a renewed increase in global risk aversion. If this happens it may prevent an actual hike from taking place. Still, the risk of such a repeat of the August-September scenario seems smaller than three months ago because EM momentum is showing signs of stabilization while global risk appetite is showing a recovery. That trend contains a significant self-fulfilling aspect — if risk appetite continues in the current positive direction, it will provide further support for EM.
In this environment an actual Fed hike can conceivably take place without upsetting these trends, especially if that hike is accompanied by clear forward guidance that the pace of hiking will be very gradual for the foreseeable future. We therefore do not consider a rate hike as a threat to the markets. We see it more as a sign of confidence that EM weakness is not impacting the developed economies too much. It may also signal more confidence in the inflation outlook, and investors concerned about the lack of nominal growth may feel more at ease.
Spread Products upgraded to small overweight
We upgraded Spread products further to a small overweight. Risks related to EM and corporates (leverage and earnings) linger, but are moderated by a bottoming in short-term cyclical indicators in developed as well as emerging markets. Weak commodity prices still pose a risk, particularly for US High Yield and EM hard-currency debt. Another risk factor is a lack of market liquidity for Spreads. Nevertheless, easy central bank policy may spur some search for yield and decreased uncertainty over the monetary policy outlook is a positive.
Real Estate raised to medium overweight
Real Estate was upgraded to a medium overweight. Increased visibility regarding the global cycle and the policy mix supports the asset class. Moreover, merger and acquisition activity in the sector is picking up and underlying fundamentals remain supportive: stronger labour data, better consumer confidence, positive impact of oil prices on retail sales and rising house prices. Real estate remains the biggest beneficiary of the search for yield from institutional and private investors. Within real estate we have a small overweight European real estate. ECB QE and a strengthening labour market should offer some support and pricing is not excessive.