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Traders work on the floor of the New York Stock Exchange on the last day of the trading year on December 31, 2018. The Dow finished up over 250 points on the final day of 2018. Photo: AFP
Opinion
Patrik Schowitz
Patrik Schowitz

The Federal Reserve’s dovish stance might not last as long as exuberant investors expect

  • While markets’ optimistic response to progress on a US-China trade deal and Chinese economic stimulus seems sensible, expectations that the Fed will continue its leniency in this cycle may be overblown
Patrik Schowitz
Patrik Schowitz
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It has been a wild ride in markets, with global equities falling by 17 per cent between early October and late December, only to regain almost all of that in 2019.

In hindsight, we can now discern the two principal drivers of those serious market moves, which should help us figure out where markets may go from here.

First, global economic activity late last year took a much bigger hit from the US-China trade war than most analysts had anticipated. This was partly due to actual tariffs introduced, but even more to the hit to business and consumer confidence from fears of further escalation. And this was not confined to just the US and China, but also the export-heavy economies in Europe and northern Asia.

The market reaction to this was predictably negative, as investors struggled to tell whether this was just a temporary slowdown or the beginning of a full-blown downturn.

Second, it occurred at the same time markets were also getting increasingly worried that the US Federal Reserve – still the world’s most important central bank – would just ignore rising economic fragility and keep raising interest rates, while also slowly reversing earlier bond purchases. The ongoing slowdown in the Chinese economy, even before any trade impact, did nothing to calm nerves.
US Federal Reserve chairman Jerome Powell speaks during a press conference in Washington on December 19 after the central bank raised short-term interest rates by a quarter of a percentage point, but signalled a slower pace of rate hikes in 2019. Photo: Xinhua
What turned things around was better news on all these fronts. As trade negotiations continued, it became a widely accepted view that both the US and China are genuinely working towards some sort of resolution that takes further tariffs off the table, even if some of the bigger structural issues remain unresolved. The economic news flow made it clear that while the damage from the trade war was – and still is – real, the global economy is not in a downward spiral.
Steady increases in stimulus from Chinese policymakers have also helped markets gain confidence that Chinese growth will eventually improve. But most important in spurring the market recovery was the abrupt dovish pivot by the Fed in January. From signalling steady rate increases, the Fed changed to indicating a pause and patience on further hikes, along with a new-found willingness to let inflation overshoot a little.
A review of the Fed’s policy framework might eventually produce structurally looser policy, although this would take time. The message from the Fed’s most recent policy meeting this week even further underlined this new dovish stance.

The market’s positive assessments of the better news on growth and US-China trade seem sensible, but an overly bullish interpretation of the Fed’s new stance ought to give room for pause.

Many investors now think that either the Fed is done with rate hikes altogether for this cycle, or might even cut rates if the economy deteriorates – and that this provides room for another strong equity market rally. They draw parallels to the 2016-17 period. A global economic slowdown, falling oil prices and a slowing China were met in December 2015 with the first hike in US interest rates since the financial crisis. This spooked global markets, which led to the Fed refraining from further hikes for a year, while stimulus eventually stabilised the Chinese economy. This led to a two-year rally, with global equities rising by around 50 per cent.

Admittedly, there are some parallels to the current situation, but there also are fundamental differences that explain why the outlook today is less bullish. The 2016-17 rally was in large parts caused by a US corporate tax cut that won’t be repeated. It is now also much later in the economic cycle with less spare capacity and higher inflation risks: at the end of 2015, the US unemployment rate was 5 per cent; today it is at 3.8 per cent.

Wages in the US have finally begun to rise, and while the Fed may have spoken dovishly this week, this may not last that long if inflation picks up. In other words, if things do go well in the economy, interest rate hikes may well be back on the table sooner than the optimists hope.

Conversely, a cut in US interest rates is likely to be preceded by a run of bad news, which would drive markets significantly lower. So, while the greater degree of caution by the Fed and other central banks is welcome, it should not be cause for exuberance. The economic and market outlook is not terrible, but big and sustainable gains in markets from here will need to be driven by good news from the real economy, and not just hopes for central bank leniency.

Patrik Schowitz is a global multi-asset strategist at JP Morgan Asset Management

This article appeared in the South China Morning Post print edition as: Fed’s dovish stance might not last as long as investors expect
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