2018

As expected, in a unanimous decision, the Federal Open Market Committee (FOMC) raised interest rates by another quarter percentage point to the 2 to 2.25% range – its third hike this year and the eighth increase of this cycle.

The FOMC’s projections for policy over the next couple of years following the September meeting were mostly unchanged from June. The Fed’s “dot plot” showed 12 officials now expect another quarter percentage point rate hike in December, up from eight officials in June’s projections. Only four officials now pencil in a pause in December.

At the same time, Fed policymakers expect another three hikes in 2019, and one more in 2020.

Perhaps the most striking change of this most uneventful meeting was the removal of previous assurances that policy was still “accommodative”. But Fed Chair Jerome Powell was quick to clarify that “dropping accommodation does not change anything with regards to the path of policy”. Put simply, policy tightening is not near an end. The current gradual tightening path is set to continue into 2019.

Removing the reference to accommodative policy implicitly acknowledges that interest rates are not far from neutral. One can think about the “neutral rate” as the “goldilocks” interest rate that keeps the economy operating on an even keel. It’s neither too low that it would boost economic activity nor is it too high that it would restrain growth. Yet, this neutral rate is not directly observable and thus not precisely measured. It is purely an estimate and its range can be broad. The FOMC estimates the neutral rate to fall within the 2.5 to 3% range. Hence, another 25 basis points hike in December this year will push the fed funds rate into neutral territory. 

Given the type of ambiguity inherent in estimating this rate, the decision to drop the reference to policy accommodation could underscore the transition to a more uncertain environment for monetary policy. Flexibility will be necessary when navigating through such an uncertain environment. Hence, unshackling themselves from such definitive statements provide some degree of freedom with which to calibrate the pace of interest rate increases over the next couple of years, contingent again on how economic variables evolve and forecasts change. Ideally, the Fed would like to prolong this period of positive growth without unnecessarily tipping the economy into a recession as a result of policy mistakes.  

The drop in the accommodation reference follows a previous announcement that Fed Chair Powell will hold a press conference after each of the eight FOMC meetings (currently it is one-on, one-off) next year, making each meeting “live” for a policy change. Again, this provides flexibility to make salient changes to policy as and when necessary.

Rising interest rates in the US is also being accompanied by a shrinking balance sheet. The Fed ended quantitative easing in 2014 and began the process of winding down its balance sheet (termed quantitative tightening) in October last year. The policy has continued to operate on auto-pilot in the background, with the Fed gradually stepping up the pace of withdrawal. This will reach the maximum velocity of US$50 billion per month from October this year.

The pursuit of policy tightening comes at a period when growth is undeniably strong and labour markets are unambiguously tight. Aggregate economic activity remains robust with Purchasing Manager Indices (PMIs) firmly in expansionary territory and GDP growth largely above potential – all this despite the spectre of Trump’s trade war hanging over the macro environment (see Chart 1).

Inflation risks remain relatively benign with the Fed’s favourite core Personal Consumption Expenditure (PCE) inflation touching its 2% target (see Chart 2). Wage growth has been tepid, but recent indicators show a more pronounced upward trend. Labour market sentiments are firmly positive as well, with quit rates hovering at record highs (see Chart 3). Wage pressures will no doubt feed into inflation, but this will likely be a slow-moving change, as evidenced by the experience of the past few years.

2019

Looking ahead to 2019, the Trump administration’s fiscal stimulus should continue to support growth, even if the din of trade tensions breed uncertainty. Inflation will continue to find support from a tight labour market and Trump’s demand stimulus. Given such dynamics, the next perhaps 2 rate hikes are more or less straight forward decisions.

It is when the juice of fiscal expansion has run out that the economic outlook becomes particularly uncertain. The effects of Trump’s fiscal stimulus may fade further into 2019.

If such strong growth is indeed self-sustaining and core inflation accelerates, in part due to trade tariffs, the Fed may be forced to become more aggressive than what they let on to be, meaning that the US central bank would have push interest rates faster and higher than expected.

Meanwhile, if growth falters and inflation does not pick up materially, then the Fed could pause hiking interest rates altogether. A flat yield curve would make this a prudent move.

Both these scenarios – runaway inflation in the first and possible recession in the second – could be problematic for markets.

We take a more middle ground in our forecasts. We expect a moderate slowdown in growth into 2019 with a gradual pick up in core inflation, which would support the Fed’s current pace of one hike per quarter through the end of 2019. Hence, we see 4 rate hikes in 2019.

Admittedly, geo-politics tend to complicate economics. We would be more confident that the third scenario plays out insofar as we observe trade tensions simmer down and geo-political stability return in 2019. Sure, the latest round of 10 to 25% tariffs on $200 billion worth of Chinese imports may not have a material impact on the US$20 trillion US economy, but one should not underestimate the potential for escalation when abrasive and confrontational heads steer the wheels of national policy.

Should the politics of trade worsen to a degree that growth slows down significantly, and inflation spikes due to tariffs, the Fed may have a difficult choice ahead. As it is, the US government’s finances are stretched following the Trump administration’s fiscal expansion, limiting the use of fiscal policy as a countercyclical measure (see Chart 4). The Fed may find itself, once again, the only game in town.

2020

It’s difficult to predict with any amount of clarity and/or accuracy what 2020 has in store. US recession risk is plausible, especially if fiscal policy reverses or fiscal tightening takes hold as the government would need to rein in spending somehow given the worsening budget deficit position. As mentioned earlier, a sharp escalation or broad worsening of trade conflict could bring forward recession risks. At this stage, this is far less clear.  

Positioning for more rate hikes ahead

We are now nearing the start of the tightening phase of the monetary policy cycle where interest rates are assuredly heading higher, at least for the foreseeable future. Yet, we believe there is still scope to be generally constructive on equities even as interest rates rise.

Quite clearly, the Fed is increasing interest rates for good reasons – US growth is strong, inflation is finally on target and the labour market is at full employment. Robust demand-side activity, healthy economic growth and strong earnings provide valid reasons to remain fairly constructive on stocks.

At the same time, interest rates are not at levels that will drag down growth and corporate earnings. The Bloomberg financial conditions index for the US remains loose despite rising interest rates, which provide some indication that the current interest rate environment remains accommodative for risk assets. Interest rates will only start to bite once the Fed breaches the neutral rate. By the Fed’s own estimations, this may only be a concern some time in mid-2019 or later. We still have time.

However, the hand-off from policy accommodation to policy tightening is typically a tricky affair and may engender higher volatility. 

Hence, maintaining a diversified portfolio will take on greater importance amid a potentially rocky investment terrain ahead. With this in mind, actively managed multi-asset funds may help to navigate turbulent conditions ahead

Our top pick is:

• Fund name: BlackRock Dynamic High Income Fund
• Fund strategy: The Fund seeks to provide investors with a non-guaranteed monthly pay-out of 7% per annum by investing 70% of its holdings into non-traditional sources of income such as Global REITs, Commercial mortgage-backed securities, Covered call writing, Institutional preferred stock, Collateralised loan obligations/Floating rate loans and Non-agency mortgages.

Meanwhile, amid a rising interest rate environment, floating rate bonds offer significant diversification benefits to fixed income portfolios with already large allocations into conventional fixed rate bonds.

Coupon rates of floating rate bonds tend to adjust upwards in response to higher interest rates. These bonds also exhibit very low price-sensitivity to changes in interest rates and low price-volatility in comparison to prices of traditional fixed rate bonds.

Yet, while floating rate bonds help mitigate interest rate risk, investors will still be exposed to credit and liquidity risks when investing in this asset class – or any type of bond for that matter. As such robust credit selection is important to ensure that investors limit exposure to companies at risk of default or debt restructuring. In addition, diversification across bond issuers, business sectors and geographical regions remain critically important to build a resilient portfolio and minimise single issuer risk.

With these in mind, interested clients should approach investments in this space in a diversified manner, that is through a unit trust that has a robust credit selection framework and a strict risk management process in place.

Our top pick is:

• Fund name: Allianz Global Floating Rate Note Plus Fund 
• Fund strategy: The Fund offers investors access to the global floating rate note universe, providing an attractive way of capturing credit spread premia, without incurring material duration or currency risks.