The US growth cycle is now the second longest in history. Trump’s fiscal plan will help keep growth on a strong footing this year and next. But this policy is not without risk at this advanced stage of the cycle: with the economy running near full capacity, inflation will likely pick up, forcing the Fed to normalise policy a touch faster. In short, such pro-cyclical fiscal policy increases the risk of a ’boom-and-bust‘ scenario, which may materialise in a downturn in 2020. Already inflation measures such as wages and core CPI have picked up. As a result, the Fed’s stance has toughened up: „a number of participants“ are now contemplating a „slightly steeper“ rate hike cycle (source: minutes of the FOMC March 2018 meeting, published on April 11, 2018).
Arguably, the federal funds rate target, currently at 1.50%-1.75%, is not high by historical standards: the 30-year average is at 3.31%. The 10-year average however stands at only 0.50%. We are looking for three more rate hikes this year, and a cycle peak around 3.30% - well above the current market estimate (about 2.50%). By some measures, the Fed is already getting restrictive: 2-year real swap rates are trading around 0.5%, above commonly used measures of the natural rate of interest (about 0.0%). Our analysis shows that, as the Fed enters a more restrictive territory, equity and rates volatility tend to pick up - making global markets more difficult to navigate. Also, a tougher Fed stance usually sees a rise in the correlation between equity and bond markets; this is bad news for balanced and risk parity funds, and usually leads to de-leveraging and de-risking.
There is a silver lining. While the timing of the fiscal impulse is questionable, it could still have long-term positive effects on the economy. In particular, it is likely to feed the recovery of business capital expenditures (capex), which for long had been the missing link of this growth cycle. The capex recovery is global and particularly significant in the US. A rise in capex is usually followed by productivity gains, which are not only the ultimate route to wealth creation but also good for corporate margins. Productivity gains tend to push real rates up (bad for risk-free bonds), but limit the negative effect of that rise on risk assets.
The main threat to the capex recovery lies in an escalation of the trade sanctions, even though this is not our central scenario. Trade wars are a lose-lose strategy: each party ends up in a weaker position (no transfer of output). Even President Trump knows this. The Smoot-Hawley tariff of June 1930 is a painful memory, as the Act proved very counterproductive for the US. Arguably, the redistribution effects associated to globalisation - e.g. the negative impact on the the low-skill labour force in developed countries - and political forces may lead policy makers to deviate from the optimal cooperative equilibrium. However, we are seeing early signs that China is willing to progressively open its local markets, e.g. in the automotive sector. Even small concessions may suffice to soften Trump’s stance.
In all, the near-term global growth outlook stays positive, even in Europe, where temporary factors have exaggerated the recent soft patch. Global bond yields are set to increase moderately, along with inflation. Equities should remain a preferred home, especially in the euro area given decent valuation, a cautious ECB and a stabilising Euro. But investors will keep in mind that the US cycle is mature, the risk of a ’boom and bust‘ has increased and the equity market upside is limited. Expect them to start rotating from stocks to bonds when 10-year Treasury yields break above 3.50%.