By Ryan Long, CFA
It was rumored again in recent months that Fed might use June as another jumping off point for a 2nd rate hike, but it was again not to be. With the poor employment situation report for May and tight polling for the upcoming ‘Brexit’ vote in the U.K. that could cause market disruptions, the FOMC was provided with several ready excuses to not proceed.
In today’s statement, it was noted that the pace of labor improvement has slowed, while economic activity appears to have picked up, as has housing. As household spending has improved, business spending/capex has remained soft. Inflation was acknowledged as remaining little changed, and running below target.
The ‘dot plot’, which is a chart in the FOMC meeting supplemental materials that lays out future fed funds rate expectations by various members of the committee, was also little changed, but did flatten a bit, reflecting the weaker outlook. These are closely watched as they tend to reflect member sentiment about where rates are headed and how soon they’re apt to get there. These plots have been overly optimistic for over the past few years, only for the timing to be pushed out several times. Wednesday's outcome was not a surprise, with fed funds futures markets predicting a minimal 2% probability of a quarter-percent boost in rates. July isn’t bullish, either, with a 20% chance, while September and December lie at 35% and 50%, respectively. These are subject to dramatic changes, though, based on new data, but odds at this point aren’t high. What’s the hold up and the status of underlying key conditions of the Fed’s mandate?
Economic growth: First quarter growth disappointed, coming in at under +1%, but there are continued hopes are for improvement in Q2. Shorter-term estimates vary dramatically among economists, which is a bit unusual, with growth for the full 2016 year slated to be in a percentage range of the upper 1’s to lower 2’s. Growth during the post-crisis recovery has never been dramatic, but concerns now are centered around the economic cycle running out of steam, without reaching the bubbly excesses that usually rise to the surface towards the end of cycles. We are seeing higher debt levels (from both governments and corporations), but not the excessive risk-taking and behavioral ‘animal spirits’. To the contrary, sentiment has never become exuberant, generally staying in the bearish to neutral/skeptical camp for extended stretches (which is not how economic and market cycles normally end).
Inflation: CPI remains low on a headline level (+1.1% over the past 12 months), helped by the sharp decline in oil prices over much of the past year, while core CPI has crept higher in recent months (+2.1% year-over-year), with price increases in non-energy items, such as shelter/rents as well as healthcare and other services. Expectations looking forward are more tempered, however, with anticipated price indexes remaining in the 1-2% range. Pressure from wage increases has occurred to a minor degree, but not to the extent the Fed had anticipated.
Employment: Labor markets have been the bright spot in the recovery. While the ‘quality’ of the jobs being created is debated, and labor force participation remains less than ideal due to demographic shifts and other underlying trends accompanying lower productivity, payrolls have been decent (with the exception of last month) and the unemployment rate is signaling near ‘full’ employment. Other metrics, like jobless claims, remain in very positive territory. In other words, it may not get a whole lot better than this, but that’s not to say there couldn’t be some additional improvement.
From a relative global standpoint, the U.S. is still looked at as being in fairly decent shape, despite the challenges in an absolute sense. When compared to peers in developed Asia and Europe, where growth is very difficult to come by, it might even be seen as downright robust. In fact, the Bank of Japan looks poised to conduct more monetary easing, and the European Central Bank could well do the same if growth and inflation falter further relative to targets. In short, growth of any sort around the world is hard to come by these days.
Accordingly, equity valuations have recovered from lows earlier in the year and bond yields have again fallen as investors are digesting a variety of global uncertainties—including hoped-for recovery in Chinese growth, the Brexit vote (next week, with odds stubbornly near 50/50) and the sustainability of the recent oil price recovery and carryover to equity earnings growth this year. Diversification hasn’t been in favor for the past several years, as traditional U.S. stocks and core bonds have dominated, but such things are cyclical, and valuations are selectively attractive in other areas, including foreign markets—developed and emerging.