Speculation about the possibility of an eventual impeachment of the US president finally triggered a market correction last week, albeit only for one day. Using political controversies for clues on the market’s direction is likely to remain a losers’ game, because the key parameters for the economy and the markets are still being set by Janet Yellen rather than Donald Trump.
Next week, we will be starting preparations for the quarterly review of our tactical asset allocation (QTAA). In that context, among other systematic inputs from a number of in-house teams, we also take a look at key macroeconomic expectations - i.e. for econom-ic growth, inflation, interest rates, and currencies. We focus on the US, which remain the key economy in the global financial system.
Monitoring the level and the changes in medium-term expectations over time helps us filter out the noise produced by short-term data fluctuations and daily media headlines. Further, we distinguish between expectations implied by the prices of tradable instru-ments from those that are formulated by policy makers and financial analysts. The current situation can be summarized as follows:
Despite talk about evaporating «Trumpflation» hopes, top-down forecasters’ expectations have actually only marginally slipped, while bottom-up corporate sales projections for the next 12 to 24 months have improved somewhat recently (corporate revenue is closely linked to nominal gross domestic product, i.e. NGDP). That said, the big picture is little changed from the previous two quar-ters - US growth is simply expected to return back to its rather modest long-term average. Implied earnings projections, meanwhile, are broadly in line with NGDP growth, which is not an extreme prediction. Any «Trumpflation» boost was modest anyway, as three-quarters of the upward revision happened before the US election. From this perspective, earnings could well keep surprising on the upside.
Here, we see a potentially important change: Forecasters’ and policy makers’ inflation projections remain little changed, but market-based expectations have started to fall since the Fed’s rate hikes last December and especially last March. Except for the inflation swap markets, most inflation-linked market instruments now suggest the Fed will undershoot its 2% inflation target in the next few years. This could imply that the Fed will probably prove less hawkish than people expect at present. Alternatively, if the Fed doesn’t relax its current policy stance, it suggests that growth expectations will also start to deteriorate over time.
The gap between the markets and the consensus views is also evident in policy rates expectations. The consensus has turned more hawkish, probably assuming a rise in the Fed’s projections next month. The consensus median calls for a maximum gain of 100 basis points over the coming 24 months, while market-based projections have refused to follow, implying only half that gain at most. This too suggests that the Fed’s current policy stance will need to be relaxed in the near future - or risk some degree of market volatility.
The most potential investment consequence probably concerns the US dollar, where we have seen a collapse in extreme bullish out-lier forecasts against the euro and the yen, and to a lesser degree against the British pound over the past three months. This too suggests that the Fed will relax its policy outlook somewhat in the coming weeks, at the very least relative to the stance of the other central banks. That would be supportive enough for equities, but not so good for the US currency. Alternatively, if the Fed fails to smoothly transition to a more flexible policy stance, we could finally see a more meaningful gain in financial market volatility, and downward revisions in growth and inflations forecasts.
Note: The next edition of the LGT Beacon is scheduled for 14 June 2017.