Penn Mutual Asset Management CIO Mark Heppenstall contributed an article to The Hill where he discusses the Federal Reserve’s (Fed) shift in strategy as geopolitical tensions continue to cause swings in the market. Mark emphasizes that investors must increasingly look both home and abroad to understand the outlook for Fed decision making as speculation surrounding a fourth rate hike in 2018 grows. The post originally appeared on The Hill on 7/5/2019 and can be found below.
Entering 2018, the outlook for global economic growth appeared unambiguously bright for the first time since the financial crisis. World economies were ready to shift out of neutral as the “global economic upswing that began in mid-2016 had become broader and stronger,” as reported by the International Monetary Fund 2018 World Economic Outlook. While the U.S. economic expansion was arguably long in the tooth, the rest of the world had plenty of runway left with easy money still the motto for almost every central bank outside of Washington, D.C.
Two years of nearly uninterrupted strength across financial markets validated the synchronized global growth outlook. Market tranquility, however, ended abruptly in early February just as Jerome Powell took over leadership at the Federal Reserve. A record spike in the equity market’s “fear gauge,” or VIX, could be easily explained away as an isolated event tied to a few ill-advised bets that the recent low-volatility environment would last indefinitely. However, as pockets of economic and financial market stress pop up more frequently this year, the positive global growth outlook looks increasingly fragile.
Even though the Fed focuses primarily on domestic economic performance to formulate monetary policy, Jerome Powell and company must increasingly consider the worldview. International economies are more interconnected than ever before through long-term trends towards globalization. The dollar’s reserve currency status puts additional responsibilities on the Fed as the world’s de facto central bank.
The Janet Yellen-led Fed specifically referenced global events when considering the end to its extended zero interest rate policy. Following a surprise devaluation of the Chinese yuan in August 2015, “Members noted that recent global and financial market developments might restrain economic activity somewhat as a result of the higher level of the dollar and possible effects of slower economic growth in China and in a number of emerging-market and commodity-producing economies,” as outlined in the September 2015 Federal Open Market Committee (FOMC) Minutes.
Just four months later, global central bankers implemented a rumored secret monetary policy agreement, which came to be known as the Shanghai Accord. The Fed and other central bankers agreed to ease pressures on emerging-market economies by delaying additional rate hikes until commodity prices recovered and the U.S. dollar weakened. Another global event shortly thereafter, a surprising outcome for the Brexit referendum in June 2016, postponed a second Fed rate hike until its December meeting.
A similar story is unfolding today with global market and economic vulnerabilities likely to alter the path of Fed policy. Rapidly growing dollar-denominated debt issued by emerging markets poses risks to financial markets and economies everywhere. The Bank for International Settlements estimates that U.S. dollar-denominated debt issued by emerging economies doubled to $11 trillion in the last 10 years. Emerging economies remain the most vulnerable to the Fed hiking rates too quickly and the accelerating pace of quantitative tightening (reduction of Fed balance sheet government bond holdings). The Powell-led Fed is entering uncharted territory for central bankers following a decade of unprecedented global central bank accommodation.
Turkey, Argentina, and Brazil have experienced significant currency declines this year and face mounting credit pressures should the U.S. dollar strengthen further. A doubling of credit default swap spreads for all three countries, since the start of the year, signifies the heightened fear among investors. Growing political populism across Europe and escalating trade tensions with China further complicate the Fed’s path forward.
The great debate for markets this year is whether the Fed hikes interest rates a total of three or four times. As recently reported by MarketWatch, there has been growing speculation that Jerome Powell was the swing vote at the June meeting of the FOMC that pushed the updated “dot plot” (interest rate forecasts for each FOMC voting member) to four hikes from three. Investors must increasingly look both home and abroad to understand the outlook for Fed decision-making. With the global growth outlook dimming rapidly, I believe the Fed will err on the side of caution and tighten more slowly than markets, and now possibly Fed Chair Powell himself, expect.