Framing the “What Ifs” for 2019

Philip Lawlor, Managing Director, Global Markets Research, FTSE Russell
Philip Lawlor, Managing Director, Global Markets Research, FTSE Russell
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Many readers will be aware that FTSE Russell, part of London Stock Exchange Group, calculates tens of thousands of equity and bond indexes, such as the FTSE 100 and FTSE 250, both in the UK and around the world. There are currently over $16 trillion of assets benchmarked to FTSE Russell indexes.

This data also gives us unique insight into global trends and sentiment towards stocks and markets; from this we can draw some interesting thoughts as investors begin to look to 2019.

A case in point, it is often said that when America sneezes, the rest of the world catches a cold.

Therefore, is there too much complacency about the future trajectory of US interest rates?

As a turbulent 2018 draws to a close, markets face a different investment landscape than what has prevailed for most of the post financial crisis era. This stage in the cycle calls for a clear-eyed assessment of the potential risks that could upend long-held assumptions and catch markets off guard.

The persistent gulf between market-driven rate forecasts and those of Federal Reserve rate setters suggests that investors remain sceptical that the central bank will stick to its proposed tightening path.

Such scepticism has served investors well over the past decade, as similarly sudden spikes in response to nascent signs of inflation were quickly followed by equally swift contractions as inflationary pressures abated.

However, there is clearly a risk that the tightening US labour market (buoyed by the boost to aggregate demand from Trump’s tax cuts) has now reached an inflection point. US wage growth has posted sequential increases over the past few months and now looks to be breaking to the upside.

As we see it, a big question facing investors is what probability they would assign to US wage growth moving to a level that would trigger a different Fed and market reaction? Wage growth would not have to climb much higher from current levels for the narrative around cost-push inflation to change.

Is the market relying too heavily on the persistence of a Goldilocks economic outcome? This is where growth isn’t too hot, causing inflation, nor too cold, creating a recession.

History tells us that there is a tipping point at which monetary policy morphs from being seen as gently “tapping” on the brakes (still accommodative) to being viewed as restrictive, with each successive hike seen as “slamming” on the brakes. That point has typically come when nominal interest rates exceed 50 per cent of nominal GDP growth. We can see that the spread between

nominal GDP and US Fed funds rates, an extrapolation of which would indicate that this tipping point is not far away.

Our proprietary, multi-metric Financial Conditions Indicators (which consider moves in currencies, bonds, interest rates and other variables) has seen the US composite score rise to a level just below 4 over the past year. A move from 3 to 4 is deemed as tightening, while a move above 4 would be deemed as tight and regarded as a potential headwind for equity returns. This contrasts starkly with the still accommodative scores for the Eurozone and Japan.

So, are we reaching a tipping point in markets?

As they grapple with growing threats posed by a steadfast Fed rate-hiking regime, a slowing global economy and a dimming profit picture, there is a heightened sense of risk aversion amongst global investors as 2018 comes to a close.