Market sentiment has improved at the end of the first quarter 2016 as threats of global economic turmoil have abated
Developments during March 2016 suggest to us that the US may have avoided the global migration of disinflationary pressures
Adverse developments in foreign economies continue to weigh on US markets
Financial conditions have eased considerably in the last few weeks but the recovery remains fragile and susceptible to global economic developments
Are the headwinds to US monetary policy normalization fading? Throughout the course of 2015, the US Federal Reserve (Fed) delayed tightening measures in response to numerous challenges including US dollar appreciation, disinflationary pressures and global market turmoil. Data published during the month of March 2016 suggests that some of these forces may be in decline. After significant appreciation, the trade-weighted US dollar appears to have stabilized, holding a defined range over the last year.
Inflation data, which had been lagging in the recovery, has surprised to the upside (see exhibit 1 below), potentially indicating the early stages of a trend to the Fed’s target. Meanwhile, market sentiment has improved as threats of global economic turmoil have abated (see exhibit 2 below). Policy patience may be tested in the coming weeks if the green shoots of spring begin to flower.
The strong dollar has been the primary challenge of interest-rate normalization with negative implications for export growth and corporate profitability. Export-driven corporations have seen revenues fall as US goods became increasingly expensive in global markets and earnings at US-based multinational firms have been negatively impacted by foreign currency translation.
The current decline in corporate profitability remains a valid concern, though we may see a reversal of this trend in the coming year if the dollar remains stable. The impact of exchange rates on corporate profitability occurs with a discernable lag. This current period of weakening corporate profitability may be more reflective of the strong dollar trend which subsided over a year ago.
Exhibit 1 : The US 10-year breakeven inflation rate has risen since mid-February 2016 reflecting, in our view, market perceptions that disinflationary risks to the US economy are receeding – the graph shows the changes in the US 10-year breakeven inflation rate during the period from 01/01/16 to 28/03/16.
Source: Bloomberg as of 28/03/16
Recent developments suggest that the US may have avoided the global migration of disinflationary pressures. Core consumer price inflation has been running ahead of market expectations in the first quarter of 2016. While recent data can hardly be characterized as a trend, inflation data has been encouraging. Domestic providers of goods and services have had limited pricing power since the global credit crisis.
A modest firming of price pressures would be interpreted as a positive indicator for the demand side of the economy. Market-based measures of inflation expectations appear to have adopted a more sanguine view of US inflation dynamics, reversing the downtrend in breakeven inflation measures.
The US, however, is not immune to exogenous forces. Adverse developments in foreign economies continue to weigh on US markets. Global market turmoil roiled markets in the first quarter. Risk aversion swept over markets, driving equity prices lower and credit spreads wider. The dreaded R word (‘recession’) began to appear in leading publications.
Fortunately, the correction was short-lived and a V-shaped retracement followed. This rather brief period exposed how susceptible US markets have become to shifts in global sentiment. Despite the fact that economic data has improved since year-end, the Fed remained cautious in March, preferring to see additional confirmation that the storm has passed. Paradoxically, expectations for a delay in Fed tightening was the likely trigger for the shift in sentiment as risky assets have been negatively correlated with interest-rate policy.
Exhibit 2 : After rising in the first six weeks of 2016, the risk premium (aka ‘the spread‘) of the Markit CDX NA investment-grade credit has fallen since mid-February 2016 reflecting an improvement in market sentiment with regard to the outlook for ‘risky assets‘
Source: Bloomberg as of 28/03/16
2016 appears to be unfolding in a similar pattern to prior years with year-end market optimism quickly replaced by broad-based risk aversion. Market correlation increased as the flight to quality ensued. As the apex of negativity was reached, the pattern reversed and the steps were retraced.
Financial conditions have eased considerably in the last few weeks, but the recovery remains fragile and susceptible to global economic developments. While we respect the Fed’s restraint on US monetary policy action following the recent market experience, we are mindful of the fact that market surprises are symmetric – perhaps 2016 will surprise to the upside.
Article written in New York on 28 March 2016