The Federal Reserve has stated that they will raise the policy rates by a quarter per quarter. That comes on top of the quantitative tightening that the Fed is doing, while the ECB will stop its quantitative easing program. Given that economic growth is still above trend and inflation is picking up we expect the trend of monetary tightening will continue. It will not derail the economic story, but will continue to have an impact on markets. Parts of the markets dependent on US dollar liquidity will be most at risk regardless of the underlying fundamentals. That is leading us to downgrade our view on emerging markets debt. Within equity we retain the preference for EM equity.
Decent economic growth continues
Developed economies continue to grow at above trend levels. Although leading indicators have come down, these remain at elevated levels indicating that growth will remain decent. The US stand out positively, helped by the big fiscal stimulus package. The US ISM manufacturing is in booming territory, while its service sector counterpart is also strong. Unemployment is so low, that an increasing number of discouraged workers have returned to the labour market. Corporate profitability has benefitted from the corporate tax cuts, creating room for business investment, acquisitions and share buybacks. In Europe and Japan buoyant leading indicators have reversed some of last year’s gains. We expect that the appreciation of the euro, rising oil prices and political unrest in Italy may have a more sustaining impact on Europe. Also in emerging markets current economic growth is decent, but a more expensive US dollar, rising interest rates and higher oil process provide headwinds. Although consensus growth expectations of the Chinese economy remain above 6 percent, debt concerns are re-emerging. The fact that China is reversing course and easing reserve requirements will help.
“The combination of higher rates and significant balance sheet reduction starts to look aggressive.”
Central Banks and trade in the spotlight
The ongoing economic recovery has not gone unnoticed by central banks. Supported by more and more proof that inflationary pressure is rising, the Fed is now tightening monetary policy. The combination of higher rates and significant balance sheet reduction starts to look aggressive. Not only do we expect the Fed to continue raising interest rates, also the ECB is looking for an exit of its buying program. Money supply growth has come down significantly. As investors have become used to ample liquidity, removing it is one of the main concerns for risky assets such as equities. Uncertainty about trade is a second concern. In the current political environment it is hard to predict the outcome of the trade discussions between the US and China. Until now, the economic impact is limited, however, a further escalation of the dispute would be bad news for emerging markets.
Earnings season to drive US markets
Given our economic outlook which sees continued strength in the US, trade concerns and the Fed raising rates we advocate a neutral stance on equity overall. While emerging markets might be at risk from tighter money, we think there is value and sentiment is getting oversold. Positive for emerging equities is the steady improvement in the return on equities. We do downgrade our view on emerging markets debt. We think the asset class is vulnerable to the decline in central bank liquidity. Equity markets in the US continue to have momentum and we would expect that to continue once the earnings season starts next week.
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