In mid-December, we discussed how a new cyclical phase was likely during 2018, one that would provide fresh trading themes with persistence enough to enable profitable momentum-oriented expressions. A prerequisite to that new phase, was a cyclical turning point replete with friction and confusion, one characterized by correlation breakdowns and rising volatility. Sure enough, demonstrable ongoing market strife has been on full display during 2018 as investors contemplate irresolute forward policy paths and a markedly altered suite of investment opportunities relative to any other moment in the post-crisis era.
Much of this consternation emanates from the juxtaposition of a newfound real economy equilibrium that confronts forward policy paths with a remarkable dearth of historical precedent. With respect to the real economy equilibrium, readings of the output gap, borrowing costs relative to growth, and the forward path of real Fed Funds relative to labor force growth, all exhibit a real-economy state of affairs that is very close to what we would consider “normal.”
Moreover, U.S. growth tailwinds in coming quarters are powerful, as a result of massive deficit-financed fiscal stimulus now flowing into a closed output gap for the first time in near 50 years. With full employment at hand and a large fiscal impulse looming, wages will likely continue to move higher. That will combine with core inflation readings that are no longer anchored by past low year-over-year base effects, setting the stage for a series of looming inflation prints that are above the Fed’s stated 2% long-term inflation target.
Two potential paths for Fed policy
Complicating this picture, is that for the first time in modern history, the Fed is concurrently removing accommodation in two ways, by increasing the price of money (Fed funds rate) and reducing the supply of money (balance sheet runoff).
Accordingly, we see two potential paths for the Fed going forward, each with possible risks and strengths. The first path would closely resemble the so-called “dot-plot” path, where the Fed delivers the very rate hikes that are implied in its forecasts. Here, the Fed will hike six to eight times through 2019, all while continuing the balance sheet runoff, an attempt to follow the economic cyclical momentum. Afterward, the Fed would likely need to ease as the cyclical bounce fades and structural dis-inflationary forces kick back in. The trade-offs in this scenario are that market fears of inflation running too hot would be assuaged, alongside a higher risk of policy accident if the Fed becomes too aggressive in attempting to exorcise inflation before secular forces tame it organically.
The second path is the structural, long-run route, which more closely resembles what markets are currently pricing in. Here, the Fed hikes three more times in total over 2018-19 and ends balance sheet runoff now, in recognition that numerous fundamental indicators are already signaling that economic equilibrium has been achieved. This is a very safe route that reduces uncertainty around forward policy and affords flexibility to become more or less aggressive later as needed. The risk to this scenario is that financial markets may worry about a string of months where cyclical growth above potential could cause inflation to accelerate onerously.
Opportunities still glass half-full
As markets are parsing these dichotomous forward policy possibilities, long held macro correlations are breaking down while realized volatility at the bottom of the capital stack has spiked (the VIX is about 60% higher on average thus far in 2018 as it was last year). As a result, many formerly effective risk hedges no longer work in an environment where valuations are decidedly late cycle. So, considering a lack of discernible trading momentum, heightened volatility and a diminished ability to hedge, one might feel an overt pessimism toward today’s market opportunity set. Not us; we perceive a half-full glass.
To us, the story of 2018 is shaping up to be the renewed ability to get meaningful income into portfolios, without having to stretch to take risk. This is largely driven by recent Fed rate hikes combined with large short-dated Treasury issuance that is filling the system with attractive cash flow in our view.
This front-end alternative is now creating a crowding-out effect for more risky assets by providing a tangible investment alternative with much less embedded risk. Specifically, nearly 70% of the total available income stream from outstanding U.S. Treasuries can be harnessed by owning nothing longer than a seven-year maturity. Similarly, within investment-grade credit (IG), employing the metric of the ratio of yield per unit of duration makes the front-end look profoundly more attractive than at any point post crisis. And in the emerging markets (EM), FX (foreign exchange) expressions now offer a similar yield as the EM-DM (developed market) yield spread, without any duration risk, on the back of recent stellar EM spread performance. Finally, with 2018’s realized volatility occurring at the bottom of the capital stack, we favor mortgages versus longer-dated IG or high yield assets. We are watching all of this play out real-time as fixed-income fund flows are broadly shunning sectors with embedded credit and/or duration risks, in favor of freshly attractive, and lower risk, high-carry assets.
Later this year, it is likely that the friction and uncertainly that is defining this cyclical turning point will give way to a more discernible and tradable trend. Until then, we will be positioned in attractive carry assets that offer the best risk/reward than at any time during the post-crisis era.