An important shift has taken place in this economic cycle. The Federal Reserve (Fed) was finally able to start following through on its projected rate hike path, raising rates twice in just over a three-month period. By doing so, the Fed showed increasing trust that the economy has largely met its dual mandate of 2% inflation and full employment, that the economy is progressively able to stand on its own two feet, and that fiscal policy may now provide the backstop to the economy that monetary policy has provided throughout the expansion. The gauges say growth engines and market drivers may have changed: power down monetary policy, power up business fundamentals, and potentially take fiscal policy and economic growth off standby.
Thus far in 2017, the consistency of this new fiscal-led dynamic has been uneven, leading to shifting market leadership amidst low volatility and a narrow trading range for major market indexes. To be sure, in the post-election rally, the financial markets began to price in many of the pro-growth policies offered by the Trump administration. Yet, despite an initial flurry of activity, political momentum slowed, and investor sentiment dampened even as consumer and business confidence remained high. It is important for investors to appreciate that despite these developments, U.S. equity indexes managed to progress through the first half of 2017 either at, or very near, all-time highs. Moreover, signs of financial stress, based on interest rates, credit spreads, and market volatility, remained largely absent. Most importantly, even with fiscal policy on standby, the return to business fundamentals, such as renewed corporate earnings growth, can now act as a market catalyst. The Fed will still have its role to play, but monetary policy is powering down as the driver of financial market strength.
Despite the significant role of monetary policy as a market driver throughout this expansion, general investing principles have held true. The ability to form a good plan and stick to it, with judicious adaptation to the market environment, is the time-tested foundation of continued progress toward financial goals. If we are shifting to new market dynamics, including a greater role for corporate profits and fiscal policy, understanding the evolving opportunities will be important for diversified investors. Use LPL Research’s Midyear Outlook: A Shift In Market Control as your guide to the shift in growth engines fueling this market.
For the U.S. and global economies alike, the ability to stand on their own without central bank support will be key for financial markets over the balance of 2017 and beyond.
The Fed is powering down its support as it continues on the path to normalization. Considering the age of the business cycle and largely steady, though below-trend growth, the Fed no longer needs to employ emergency-level policy measures. We expect two or possibly three rate hikes in 2017 as the central bank gradually removes its support [Figure 1]. Better U.S. growth amid low unemployment will likely be accompanied by core inflation pushing somewhat above the Fed target of 2%, supporting normalization. But there are still enough forces pushing down on inflation, including excess manufacturing capacity, a low labor force participation rate, and a more stable dollar, that an extended run meaningfully above the Fed’s 2% target remains unlikely.
Job creation, which has averaged about 185,000 jobs per month so far in 2017, is likely to slow at this stage of the business cycle. But even if payroll growth were to decline to a 100,000 to 125,000 monthly pace, we suspect the Fed would still stay on track to hike rates at least twice this year. Wage growth at 2.5% remains below the 4.0% pace that has historically caused central bankers to raise rates aggressively, but has improved enough to keep the Fed on its stated track.
While such a rate hike path would be consistent with the FOMC’s statements, monetary officials will need to balance their employment and inflation mandates with the potential U.S. dollar impact. Following a significant rally from late 2014 to early 2015, the dollar has been largely range bound [Figure 2]. Imbalances may occur if the dollar gets too strong relative to other currencies, particularly in EM —representing over half of global economic output —where weak currencies relative to the dollar can lead to capital flight, higher debt service payments, and food inflation. Policymakers are mindful of this, as published statements expressed a possible shift in tactics toward a market-based form of tightening, referred to as balance sheet runoff, whereby the central bank can reduce the size of its balance sheet by tapering the reinvestment of maturing bonds, potentially beginning in early 2018.
Looking overseas, central bank policy, particularly in Europe and Japan, continues to result in low yields for developed overseas economies. With better growth emerging in many European countries, but inflation still subdued, the European Central Bank (ECB) appears to be in a holding pattern —not likely to loosen further (which would benefit bonds), but also not likely to tighten until inflation starts to pick up. The Bank of Japan (BOJ) is in a similar situation, providing more optimistic economic assessments, but still warning that stimulus will need to be maintained at current levels. The end result is low rates overseas may keep U.S. interest rates from moving significantly higher.