Do Not Fight (or Fear) the Fed (or the ECB, BOJ, PBOC)
To be sure, 2015 drew to a close with monetary policy moving in opposite directions among the major central banks. The Federal Reserve began its path of policy normalization process with a 25 basis point rate hike at its December meeting. A few central banks, like Brazil’s, are expected to switch from a tightening to an easing stance over the course of 2016 as inflation softens. Meanwhile, the European Central Bank, the Bank of Japan and the People’s Bank of China are all expected to ease further within the next few months.
The Fed is hiking not because inflation is high, but because unemployment is low. The cumulative improvement in the U.S. labor market and faster recovery in growth supports the Fed beginning to normalize policy even as other central banks are still easing. Easing by the ECB and BOJ thus partly reflects that they are not quite as far along in the post-crisis recovery cycle as the U.S. The euro area double-dipped following the 2011 debt crisis, while Japan has not been able to get into high gear despite massive amounts of stimulus. Moreover, inflation has remained disappointingly low for these central banks that focus on price stability, and further policy easing will be aimed in large part at offsetting low inflation or deflation psychologies. In contrast, the tightening U.S. labor market is starting to nudge wages higher, and the Fed sees this as a step toward higher inflation over time. This dynamic is not yet engaged in the euro area or Japan.
Despite concerns to the contrary, the most well telegraphed Fed hiking cycle in ages was not a large shock to financial markets. As for currencies and capital flows, many emerging market economies are better positioned for Fed normalization than they were during the “taper tantrum” of 2013. While the U.S. dollar may appreciate somewhat further in 2016, arguably quite of lot of policy divergence has already been priced into the roughly 20% appreciation of the trade-weighted dollar since last summer. Moreover, the Fed’s communication has made it clear that its trajectory will be slow and steady, i.e., “lower for longer.” And easing by other central banks should stimulate their domestic demand, with positive spillovers to the U.S. and the rest of the world.
The World Is A Very Big Place (And So Are The Markets)
With an economic and monetary policy backdrop as convoluted as the one we have described, it would be easy to justify sitting on the sidelines without the benefit of discernment offered by valuations. With interest rates globally at generational lows, the choice between stocks and bonds on a relative basis is easy, even with the prospect of normal short-term corrections and market gyrations picking up.
While the argument for diversification may not have always been visible in recent years, as U.S. market returns so clearly dominated those of the rest of the world, the tectonics underneath a home-biased portfolio construction started to shift in 2015, as segments of the non-U.S. developed markets saw stronger results. There is likely to be a continuation of that trend in 2016, thanks in large part to catalysts from central bank action as well as attractive valuations across the euro zone, Japan and many segments of the emerging markets.
Peak margins, negative earnings growth and a forward P/E multiple at or slightly above the historical average makes the U.S. stock market vulnerable, though M&A activity and other shareholder-friendly initiatives could keep the markets trending higher. Put another way, if the equity story in the U.S. is that things are just OK, the story in Europe and Japan is that things are getting better. Those markets have been cheap for some time, but that cheapness was not unreasonable. Fiscal policies were tight, the offsetting monetary stimulus was slight, there was no quantitative easing, and the banks were reluctant to lend. These factors are all changing.
Emerging markets have more nuances to be sure, but when the valuations are trading at their largest discounts to those of developed-market peers in 12 years, it means there are benefits to some exposure, particularly in Asian countries like South Korea and India where reforms are showing tangible progress.
If we can all agree that economic and market cycles don’t just die of old age, that fundamentals paint a picture of at least muddling growth, and that monetary policy is on the whole supportive and has decent visibility around it, it seems reasonable to argue for a diversified portfolio tilted in favor of equities (with some bonds, depending on the time horizon and risk tolerance of the investor). That’s probably not breaking news. And maybe that’s just the point for our clients—that there is no complex narrative or implementation required, just a willingness to consider the full landscape of global investment opportunities and participate with the guidance of an experienced advisor whose good judgment can distill all the noise into some basic truths and invest accordingly.
Michelle Knight is chief investment officer and chief economist of Ropes Wealth Advisors.