Strategy & economics
Economic update and outlook for 2016
If the Federal Reserve (the Fed) does not raise interest rates soon, I believe the US could move into ‘policy mistake’ territory.
All eyes will be on the Federal Open Market Committee meeting on 15th and 16th December this year. It is difficult to say with any certainty whether this will mark the pivotal moment that some investors have long been awaiting. But what is clear is that we are on the threshold of a new interest rate cycle in the US.
This will present investors with three questions. Firstly, how quickly will interest rates go up from here? Secondly, to what extent will rates eventually rise? And, thirdly, how inflation tolerant will the Fed prove?
In terms of how quickly rates will rise, my baseline assumption is that interest rates will rise by 0.25% every three months, which would mean that they are around 1% higher in the US in a year’s time. I would estimate that this process will continue into 2017, as long as growth in the US economy does not falter.
Secondly, to what extent will rates eventually rise? I view this as the ‘real unknown’ at this point in time.
It should be the case that interest rates rise towards the nominal growth rate in the economy, and that is likely to be somewhere between 4.25% to 4.75% in the US. I think it is going to take a long, long time before we get there; it might be between three to four years.
If the Fed and the Bank of England have not increased interest rates from their low levels by this time next year, we will be in the realms of a policy mistake. Worryingly, it could be similar to the policy mistake that contributed to the very fast growth that we saw prior to the recession. This was unsustainable because it was supported by huge credit creation and eventually resulted in the financial crisis.
The prolonged slump in oil prices caught many by surprise this year. In my view, it symbolises a change in the balance of growth between the West and emerging economies. Manufacturers in the latter are not growing as fast because they are not growing exports into the West as quickly. This is feeding back through the system, creating less demand for commodities and energy products. I think this is likely to continue into 2016.
It is difficult to foresee a significant change in the balance of world growth in the near term, and I don’t think we’re going to see a sufficient pick up in momentum to drive oil prices substantially higher. That doesn’t rule out a rebound from the current exceptionally low levels, but I doubt we will see a trend increase in prices.
Volatility staged a dramatic return during the summer. The bad news is that I think it could be here to stay, on account of the numerous question marks hanging over the global recovery. These uncertainties include; Chinese growth; commodity markets; the strength of the Western growth cycle; and, of course, politics. At the same time, due to ongoing quantitative easing, there is a huge and still growing amount of liquidity in the system and this can exacerbate volatility.
If volatility continues, my advice is to stay calm and try to avoid being too short-termist. Focus on the fundamentals that are supporting markets: that is, the gradually improving economic story that is emerging. Also, don’t lose sight of valuation.
In this regard, equity markets are looking reasonably valued at these sorts of levels. Sovereign bonds on the other hand, look pretty poor value to me. With yields slightly below 2% in the UK and US, in line with long-term inflation expectations, investors could see no real return over a 10-year period.
Short duration corporate bonds offer better value, as they are not as exposed as longer-term government bonds to the negative consequences of the near-term interest rate cycle. Outside of bonds, the yields on offer from commercial property currently look attractive. I would rather have money in good quality commercial property than government bonds.
One of the most common questions I get asked is: ‘When are we going to get back to normal?’ The answer is I don’t think we are going to get back to the growth environment we saw before the last recession for quite a long time. Growth rates are going to be more subdued than that. And because of that, we’re going to feel more vulnerable.
This article is issued by Cazenove Capital which is part of the Schroder Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital unless otherwise stated.