October 2017 Perspective

October 09, 2017 | Market Commentary

The U.S. Economy

On September 20th, the Federal Reserve announced that it will begin to shrink the size of its balance sheet as it attempts to unwind what has been an unprecedented buildup in central bank assets. Over the past 10 years since the Global Financial Crisis, the Federal Reserve grew its balance sheet by $3.6 trillion, an astounding 408% increase.

The process of balance sheet normalization, also known as quantitative tightening (QT), will begin slowly and build up pace over time. For October, the Fed will first attempt to shrink its holdings by $10 billion. It plans to do the same for November and December. In the first quarter 2018, the Fed anticipates doubling the pace to $20 billion per month, and increasing the pace by $10 billion quarterly, until reaching a cap of $50 billion per month by the fourth quarter 2018.

The central bank intends to conduct QT by letting the targeted amount of principal payments roll off its books at maturity while reinvesting the remaining proceeds to maintain the gradual pace. In other words, the central bank is choosing to not reinvest $10 billion worth of financial assets each month at the outset of the program–$6 billion of Treasury securities and $4 billion of Agency securities. Despite the disclosures and transparency provided by Federal Reserve officials on how the QT process is expected to unfold, the reality is one of uncertainty as there is little precedent of a central bank stepping away from the market at such scale.

In the meantime, financial conditions have continued to become easier over the past 18 months. Despite several rate hikes, falling interest rates for longer-dated fixed income securities and ample liquidity in financial markets have ensured that conditions remain accommodative. Should the Federal Reserve consider these conditions as conducive for both implementing QT and further tightening, then perhaps we could also see additional rate hikes in December and early next year.

Other factors will also play a role in determining the direction and pace of upcoming Federal Reserve policy decisions. For example, after rising toward targeted levels in 2016, core inflation readings have since drifted back lower. Future additional weakness could slow the pace of QT or rate hikes, although we expect transitory factors depressing inflation growth to dissipate over the coming months.

In contrast to recent inflation data, domestic economic indicators have been improving following a soft patch in growth. Further acceleration in economic activity may drive wage growth and boost inflationary pressures, in turn incentivizing the Fed to tighten at a faster pace than what is currently expected by the market.

From a big picture perspective, we see the initiation of the Federal Reserve’s QT program as illustrative of an inflection in monetary policy implementation, and as a sign from policymakers that the slow secular growth economy has broadly evolved as they anticipated.

The Global Economy

The inflection in monetary policy implementation extends globally as well. As the Fed embarks on QT and potential future rate hikes, the European Central Bank (ECB) and the Bank of Japan (BoJ) are confronting their own extraordinary monetary policies.

In Europe, recent chatter from ECB policymakers suggest a growing desire to slow or end quantitative easing (QE). The European QE program has been in place for two and a half years, and has resulted in over 2 trillion euros of purchased bonds subsumed by the ECB balance sheet.

Over the past year, economic conditions have gradually improved throughout continental Europe, setting the stage for an eventual return to normal monetary policy. ECB board director Sabine Lautenschlaeger alluded to the prospect of normalization last month saying, “The economy in the euro area is doing better” and “We have to be prepared to take tough decisions in good time.”

Meanwhile, the BoJ yield curve control program has thus far been successful in targeting a yield of 0% on the 10-year Japanese government bond. With rates pinned near zero, the BoJ has gradually reduced the quantity of its asset purchases while, at the same time, Japan’s economy enjoyed its fastest pace of GDP growth last quarter, expanding at an annualized rate of 4%.

Neither central bank is ready to officially commit to a return to policy normalization. However, should the global synchronized expansion persist, by the middle of 2018, we see the possibility for all three major central banks to combine for a net reduction in central bank assets, resulting in an unofficial, coordinated monetary policy tightening, with economic and market implications across the globe.

Our Perspective

Valuations in the broad U.S. stock market remain elevated. Similarly, valuations across most global equity markets remain at or somewhat above what we consider fair value, with significantly fewer pockets of cheap valuations remaining compared to the past several years. However, we continue to see few unsustainable excesses that would suggest the U.S. or global economy is at risk of imminent recession. In this environment, discernment and flexibility are critical.

Given the slow global growth environment, in portfolios geared toward capital growth, we are focused on targeting investments in fundamentally strong businesses with unique growth drivers, although we have become incrementally more comfortable owning economically sensitive names. In general, we continue to believe that the key to generating attractive returns in today’s slow growth environment is through owning innovative companies that achieve growth by creating new markets or disrupting old ones. However, as certain growth-oriented holdings reach our estimate of fair value and are trimmed, portfolios are becoming incrementally less growth tilted.

Regarding fixed income, our outlook is constructive toward credit, and although credit spreads are tight, they remain relatively attractive on a fundamental basis. As such, portfolios maintain a sizeable allocation to investment-grade corporate bonds, although some portfolios may contain high-yield exposure as well. As we are in the later stages of the economic cycle, we are monitoring corporate credit allocations to determine if any action is warranted. Portfolios also have a notable allocation to U.S. Treasuries and Agencies as well as pass-through securities, including asset-backed securities. Generally speaking, portfolios are underweight non-agency mortgages.

We continue to believe a modest duration remains in clients’ best interests. Over the intermediate-term (which we define as the next 12 to 18 months), we expect that there will be continued pressure for interest rates to gradually move higher. We think the Fed will remain opportunistic, looking to hike the federal funds target rate when economic conditions allow, while also remaining sensitive to domestic and global market conditions, particularly as they begin to reduce the size of their balance sheet by decreasing reinvestments of principal in Treasuries and Agency securities.

In our view, short-term and income-oriented investors should also explore equities that display stable fundamentals and are trading at attractive valuations. We believe companies that generate strong, stable cash flows and pay an attractive dividend could be compelling options for these types of investors in the current environment.

Source: Federal Reserve and Thomson Reuters. Analysis: Manning & Napier Advisors, LLC (Manning & Napier).

Manning & Napier is governed under the Securities and Exchange Commission as an Investment Advisor under the Investment Advisers Act of 1940.

All investments contain risk and may lose value. This material contains the opinions of Manning & Napier, which are subject to change based on evolving market and economic conditions. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.


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