Taking A Hike

04/11/2016 at 4:32 pm

Well that clinches it, surely. Today’s US data showed the unemployment rate down again to 4.9%. Payroll growth continued at a strong pace, with non-farm jobs up by 161,000 last month. Both these prints came out in line with expectations – but wage growth beat every estimate going, hitting a new post-recession high of +2.8% on the year. Purchasing manager surveys out over the last couple of months suggest that the rate of job creation will accelerate into the end of this year if anything. The American labour market is showing clear signs of warmth. Surely, a Fed hike next month is certain.

This chimes with the consensus view. Of the 66 forecasts currently made available to Bloomberg, 15 expect no change and all the rest are for a 25bp hike. The interest rate markets also expect the Fed to see out 2016 with a target rate of 0.75%, then go on to hike again around the middle of next year.

So far, so uncontentious. Indeed it is reassuring from an investor’s perspective that the market reaction to somewhat firmer expectations for interest rates has, thus far, been sanguine. Halfway through this year a December hike had yet to be priced in; by the autumn the eurodollar futures market had become unequivocal on the subject – Treasuries sold off too – but the S&P 500 still rallied, turning in its strongest quarterly performance of the year so far.

The key word there is: “somewhat”. In the US as in Britain there is now a real risk that tightening occurs more quickly than people think.

That +2.8% wage growth is part of the reason why. A connected reason is that the energy sector has recovered some of its strength this year, taking away a recent source of downward pressure on activity and employment. Then there are import prices: stable oil and a stable dollar have now closed off that source of deflation. Core CPI has already been running at its strongest sustained level this year since the Great Recession. Both the headline CPI measure and the consumption deflator used to calculate chain-weighted GDP have been catching up. Finally, unreliable indicator as it is and completely unfashionable as it has become, broad (M2) money supply growth is running at its fastest pace for nearly four years.

The question to which nobody knows the answer is: will the labour market start really overheating and, in the circumstances, contribute to an uncomfortable level of inflation? At the moment, US policymakers are split on the subject, but the Fed’s actual monetary response to date, together with the interest rate markets’ pricing, implies a near-total lack of concern.

Another wild card is our old friend political risk. At present, polling at the national level and in some of America’s “battleground states” suggests that Secretary Clinton is on course for a narrow victory. If Mr Trump were to pull off a surprise win, however, it is not just the market response but the economic consequences which could be significant. There has already been extensive coverage of the effect that the candidates’ fiscal policies might have on the national debt, but consider some of the Republican candidate’s other measures: the expulsion of migrant labour, swingeing tariffs on imports, less accommodative trade agreements (as well as big tax cuts for businesses and households). All of these would be inflationary.

It would be imprudent to expect a crisis. But the possibility of a problem is clear and what matters to us as investors is that this is not recognised – indeed, quite the reverse. Bond markets think that inflation over the next ten years will run at an average of 1.7%, below the 2.1% they have priced in on that horizon over the last 15 years. Consumer expectations for near term inflation, as measured by the University of Michigan survey, are below average too, and for long term price behaviour are at their lowest ever level.

So there could well be a surprise or two in store. And whatever its scale, this ought to have consequences for portfolio construction.

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