A portfolio manager offers an alternative to doomsayers’ explanation of movement to lower rates
The global equity markets have rallied well from being brought low by December’s bout of volatility. Still, investors around the world have been shaken, and a widespread risk-off sentiment has inspired a movement toward haven assets, fixed-income exposure, and alternative investments.
Encouraging that attitude is a continuing forecast of a day of reckoning for equity markets. The rally, naysayers contend, has been fuelled by the Federal Reserve’s pivot to easier policy. And just as a fire without oxygen can’t burn forever, they say that the equity market will eventually undergo a correction as an underlying economic growth slowdown makes itself felt.
But according to Krishna Memani, vice chairman of Investments at Invesco, that explanation doesn’t hold up. “While at first blush this may make logical sense, I firmly believe this argument suffers from a framing problem,” he said in a recent blog post.
“The basic premise of the argument is that the Fed’s pivot was driven by the US economy slowing to a catastrophic level,” Memani said. Believers in the slowdown forecast, he said, believe the central bank is privy to certain economic signals that suggest an imminent recession, so it hurriedly engaged a dovish policy lever in an attempt to avert a catastrophe.
But he presented an alternative perspective: the Fed had merely gotten ahead of itself. After the central bank concluded last fall that the US economy had fully recovered from the post-financial crisis, he argued, they decided to adopt a mantra favouring policy normalization, even allowing for some overshoot on the tightening front.
“In August to September 2018, the various Fed pronouncements were reminding us that they didn’t know where R* (the neutral Fed fund rate) was,” he said. “[I]n their inflation driven tightening frenzy, they were going to go above that unknown neutral rate.”
But by December, the Fed had come to conclude that the US economy was growing through a drastic slowdown, suggested by a 3.5% unemployment rate, and it was devoid of any inflationary pressures. Given that realization, Menani maintained that the correct and prudent response was to abandon their hawkish stance and undo their unnecessary tightening by cutting rates once more.
“If one frames the Fed pivot response in this slightly nuanced way, all the market happenings in the first half of 2019 start making sense and the outlook for the second half improves meaningfully,” he said.
The last few rate increases will be unwound gradually, he suggested, “perhaps not the 50 bps cut the markets were expecting for the July meeting.” Financial conditions may also continue easing, and the US economy will move on from its Q2 2019 soft patch, which Menani linked to the inventory buildup in Q1 2019. In case of a return to the economy’s trend growth rate of 2%, the US equity markets will rise in spite of modest increases in US long interest rates.