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The Fed—Reexamining the Future


by Brian Rehling, CFA, Co-Head of Global Fixed Income Strategy

Key takeaways

  • The Federal Reserve (Fed) is reexamining how it communicates inflation targets. Any changes in its approach could have long-term implications for investors.
  • The Fed recently announced a plan to end its balance sheet runoff at the end of September 2019.

What it may mean for investors

  • We recommend that investors consider maintaining fixed-income duration slightly below the level of their individually-selected benchmarks.1

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A significant focus for the Fed in 2019 is reexamining how it approaches monetary policy goals, including the tools it favors to implement those goals. The Fed’s overarching goals of maximum employment and price stability remain unchanged, but the U.S. economy poses unique challenges in meeting those goals today. The Fed is currently on “pause.” Further, last week, the Fed announced a plan to end its balance sheet runoff in late September. These policy implementation tools are not the only focus of the Fed’s monetary policy reexamination. A key focus is on a potential change in how the Fed’s price stability goal is targeted—and if the monetary policy toolbox should be expanded to help meet this goal. Over the past two decades, the Fed has slowly and deliberately evolved its tools and communications. The current effort could be another evolutionary step.

Why now?

Systemic long-term economic and demographic trends are influencing the potential for U.S. economic growth, and they are likely to depress inflation and economic growth rates going forward. We highlighted many of these issues in our special report “Paying America’s Bills” (first published in July 2016 and most recently updated in August 2018). These include the following trends:

  • High and growing U.S. government debt levels have a disinflationary effect—as funds that might have been used toward investment and consumption must be diverted to service the growing federal debt burden. High debt levels also limit lawmakers’ ability to address economic shocks with fiscal spending. This puts more reliance on the tools of monetary policymakers.
  • As the U.S. population ages, more of the country’s income must be diverted to support federal “social contracts” (such as Social Security and Medicare). This fiscal drag can reduce potential economic growth rates. In addition, an aging population brings with it an increased demand for income. This generally helps to keep interest rates at low levels.

Low inflation and low economic growth rates pose difficult issues for Fed policymakers. The federal funds rate stood at 5.25% before the Great Recession of 2008; yet it stood at 2.25%-2.50% last week. The current federal funds rate leaves the Fed with less rate-cut flexibility if it is needed in the future. Now, with the U.S. economy and financial markets in fairly stable condition, monetary policymakers can conduct a thoughtful and thorough deliberation before implementing any policy changes. The decisions they make could prove to be important during the next period of economic stress.

What could change?

We believe that the most likely monetary policy change could be for the Fed’s formal inflation target. Currently, the Fed has an inflation target of 2%. This worked well in the past, when the primary Fed focus was to make sure that inflation did not overheat and spiral above its formal 2% inflation target. With interest rates and inflation likely to remain depressed, this framework may prove to be less useful in the future. To address this concern, a potential policy change would be for the Fed to move toward average inflation targeting. This would focus on an average inflation target over time, rather than seeking to reach a specific inflation target at a point in time. This would permit the Fed to allow for a period of higher inflation if we experience a period of low inflation (as we did earlier in this decade)—so long as the average inflation rate meets its objective.

While any change in the Fed’s inflation targeting is likely to be the “headline” change, we also expect the Fed’s policy reexamination to provide further clarity around the Fed’s monetary policy toolbox. We expect that the federal funds rate will remain the Fed’s primary policy tool, while quantitative easing becomes the primary policy choice once the fed funds rate hits the lower bound of the “normal” range. We could see the Fed clarify how quantitative easing may be implemented when it is needed. Finally, the Fed might discuss adding the potential for a negative interest-rate policy, or even yield-curve control policies, similar to those that the Bank of Japan implemented in recent years. We would expect such policies to be implemented only as a last resort.

Implications for investors

U.S. inflation expectations have been exceptionally low for an extended period. Much of the Fed’s policy reexamination has been designed to evolve its policy in a way that could raise inflation expectations. If the Fed is able to convince markets that it can increase inflation, we could see modestly higher economic growth (as consumers and businesses could have an added incentive to spend) and higher long-term interest rates over time. These outcomes would be welcomed by most investors. Even with new policies and tools, the ability of the Fed to permanently lift market inflation expectations is suspect. We doubt that the Fed can meaningfully alter the low-growth, low-inflation environment that appears to be a feature of most highly developed countries today. As a result, we expect that relatively low interest rates are here to stay.

EQUITIES

by Audrey Kaplan, Head of Global Equity Strategy; Ken Johnson, CFA, Investment Strategy Analyst

MSCI China Index formed a “golden cross” after MSCI announcement

MSCI recently announced plans to increase the China A-share inclusion factor in its indices from 5% to 20% by November 2019. The inclusion adds large cap, mid cap, and ChiNext mainland-China-based companies. (ChiNext is part of the Shenzhen Stock Exchange and is similar to NASDAQ, with many growth-oriented technology companies.) The Chinese equity weight is expected to increase for the Consumer Staples and Information Technology sectors (in particular). Since the announcement, the MSCI China Index has formed a golden cross—a technical signal in which the 50-day moving average rises above the 200-day moving average (typically a positive market signal).

The MSCI Emerging Markets Index (MSCI EM) is one important benchmark impacted by this plan. MSCI expects this index’s A-share weighting to rise from 0.7% to 3.3%—and the overall Chinese equity weighting to rise from 32.2% to 33.5%. The inclusion may create Chinese equity market inflows from $40 to $70 billion as passive and active managers adjust holdings to reflect the change. This may fuel upward Chinese equity momentum, resulting in potential MSCI EM gains over time. 

We expect additional increases for the Chinese A-share inclusion factor. China has made progress in expanding access to its capital markets; the pace has accelerated as rising bank-debt levels in China have become a problem and firms have sought other financing methods. Also, U.S.-China trade negotiations include efforts to encourage Chinese capital-market reform. Investors have responded positively; more than 5,600 new accounts have been opened to trade China A-shares to date.

Key takeaways

  • We maintain a most favorable rating on emerging market equities, and we favor exposure above long-term target allocations.
  • China’s expansion of access to its markets (through its reforms)—and the planned MSCI A-share “inclusion” changes—could be a tailwind for the MSCI EM Index.

MSCI EM Index—impact of MSCI’s planned A-share inclusion increase


MSCI EM Index—impact of MSCI’s planned A-share inclusion increase

Sources: MSCI, Wells Fargo Investment Institute, March 13, 2019. China A-shares are shares of mainland China-based companies that are traded on the Shanghai Stock Exchange and the Shenzhen Stock Exchange in local currency (Renminbi). MSCI China Index captures large and mid-cap representation across China H shares, B shares, Red Chips and P Chips. With 140 constituents, the index covers about 85% of the China equity universe. MSCI Emerging Markets Index is a free float-adjusted market capitalization-weighted index designed to measure equity market performance of 24 emerging market countries. An index is unmanaged and not available for direct investment.

FIXED INCOME

by Brian Rehling, CFA, Co-Head of Global Fixed Income Strategy

Dovish Fed—Dovish dots

The Fed reflected a decidedly dovish tone during last week’s policy announcement. The Fed acknowledged that growth is slowing, and it announced that its balance sheet runoff is ending sooner than expected. Most importantly, it significantly altered its “dot plots.”

After last week’s meeting, the FOMC (Federal Open Market Committee) released a new summary of economic projections. Within that document was the “dot plot,” which shows the compilation of each individual member’s forecasts for economic growth, the fed funds rate, and other measures. (The “dot plots” reflect each member’s view of appropriate monetary policy at given point in time).

There are 17 FOMC members that provide their assessment of the economy and interest-rate policy in the “dot plots.” At the December meeting, 6 members projected a total of 3 fed funds rate hikes in 2019, while 5 members projected 2 rate hikes and 4 members projected 1 rate hike this year. In December, only 2 FOMC members projected that the Fed would keep rates unchanged in 2019. At this month’s meeting, 11 members forecasted no rate hike this year. This was a substantial reduction from the 15 (of 17) FOMC members who expected at least one 2019 rate hike at the December meeting.

Key takeaways

  • The dot plots show that the majority of FOMC policymakers do not expect a rate hike this year.
  • Less uncertainty around the path of Fed rate hikes could limit bond-market volatility in the second half of 2019.
  • We believe that investors should consider favoring the short part of the yield curve in an effort to help mitigate interest-rate risk and to potentially benefit from additional income potential. We are looking for a market opportunity to extend portfolio duration.

FOMC “dot plots” of fed funds rate increases


FOMC “dot plots” of fed funds rate increases

Sources: Federal Reserve, FOMC; March 20, 2019.

REAL ASSETS

by Austin Pickle, CFA, Investment Strategy Analyst

“Never ruin an apology with an excuse.” --Benjamin Franklin

Real asset reverberations from the FOMC meeting

When the Fed speaks, the reverberations are felt across markets—real asset markets included. Last week, FOMC members’ “dot plots” signaled no further 2019 rate hikes, while the Fed announced that its balance-sheet runoff will end in September 2019. In response, U.S. stocks rallied from the day’s lows, and interest rates dropped significantly. Today, we discuss some high-profile real assets impacts of the increasingly dovish Fed.

Real estate investment trusts (REITs) are highly sensitive to the long end of the yield curve. The chart below plots the relative performance of REITs (versus the S&P 500 Index) against the 10-year Treasury yield, which shows an inverse relationship between changes in interest rates and the returns of equities and REITS. Notice how the two lines track each other closely. When interest rates drop (an increasing orange line), REITs tend to outperform (a rising green line). The dovish Fed announcement caused the 10-year Treasury yield to fall, and this helped to boost REIT performance.

The Fed announcement also caused the U.S. dollar to drop. This helped to lift the commodity complex as a whole. Gold typically is the most sensitive commodity to U.S. dollar movements. In fact, gold’s price surged nearly 1% on the day of the Fed announcement. If the Fed continues its dovish track and the dollar weakens further, we would expect gold and commodities to benefit.

The economy, interest rates, stocks, currencies, and real assets are intertwined. The reverberations from one area often carry over to the others. Last week’s Fed announcement is a perfect example of this connection.

Key takeaways

  • The economy, interest rates, stocks, currencies, and real assets are all intertwined.
  • Last week’s dovish Fed announcement benefited REITs, gold, and commodities.

Global REIT relative strength (versus S&P 500) and 10-year Treasury yield


Global REIT relative strength (versus S&P 500) and 10-year Treasury yield

Sources: Bloomberg, Wells Fargo Investment Institute. Daily data: January 5, 2015 – March 20, 2019. Ratio is the FTSE EPRA/NAREIT Developed Index divided by the S&P 500 Index. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. Please see the end of this report for the risks associated with these asset classes and for the definitions of the indices.

ALTERNATIVE INVESTMENTS

by James Sweetman, Senior Global Alternative Investment Strategist

North American M&A markets slowing—concern or opportunity?

Although 2018 was the third best year ever for the North America merger and acquisition (M&A) market, activity slowed in the second half of the year—with second-half volume averaging approximately 34% lower than in the first half. This was largely driven by a stock market sell-off in the fourth quarter and concerns over the U.S.-China trade dispute weighing on dealmakers’ confidence. Although we have seen a healthy uptick in publicly-traded risk assets year to date, North American M&A volumes through February 28, 2019 remained in line with the first two months of 2018. Yet, the number of deals larger than $1 billion declined by 31% year-over-year.2

As we move deeper into the current cycle, there is apprehension that trends which were once viewed as potential concerns (slowing growth, rising trade tensions, and increasing volatility) have become issues of more immediate importance. Yet, despite the recent dip in M&A volume, we have a positive outlook for 2019 M&A activity. This is driven by several factors, including CEO (and Board) confidence still near highs (see chart); record amounts of Private Equity dry powder (capital available for investment); M&A financing remaining attractive relative to history; activist investors driving corporate activity; and technology disruption resulting in increased cross-sector and cross-border M&A activity.

Private Equity and Event Driven hedge fund strategies can potentially capitalize upon the growing list of catalysts across mergers, acquisitions, corporate carve-outs, and activist campaigns to generate compelling long-term returns, driven by the favorable factors in the M&A environment.

Key takeaways

  • Several factors suggest that significant M&A activity can continue this year, driven by innovation and disruption—traits that often are difficult to grow organically.
  • Most importantly, the strategic imperatives to increase earnings and optimize business platforms (driving corporate merger activity) have not diminished.

CEO confidence is near recent highs after falling in the second half of 2018


CEO confidence is near recent highs after falling in the second half of 2018

Sources: Bloomberg, March 20, 2019.

1 Duration measures a bond’s price sensitivity to interest-rate changes.

2 Bloomberg, March 2019.