Love Letter – February 2018

February 12, 2018

Interest rates may be rising but runway for global growth still long

2017 was a strong year for global markets as virtually every equity index finished well into positive territory. The reason for this is straightforward: co-ordinated global economic growth is occurring for the first time in many years, lifting business, consumer, and investor confidence to multi-year highs. It has taken much longer than expected, but the slashing of interest rates after the 2008-2009 financial crisis is only now having the intended widespread stimulative effect. Indeed, initial estimates indicate that 2017 global GDP expanded at the fastest pace in six years and expectations are for further acceleration in 2018.

With global economies having been rescued by prolonged ultra-low interest rate policy, central banks have now understandably turned their attention to removing this unprecedented level of stimulus. Some central banks such as the U.S. Federal Reserve, Bank of Canada, and Bank of England have already started to gradually raise rates. The European Central Bank, Bank of Japan, and Chinese central bank have yet to start. With short-term rates in Europe and Japan still sitting at -0.4% and -0.1%, respectively, pressure is building for these economies to begin removing emergency-era stimulus (exhibit 1). We would interpret a decision to raise rates in these latter regions as a vote of confidence by central bankers.

Rising interest rates and rising stock markets can co-exist, for a while

As interest rates are the fundamental driver of asset valuation, a prolonged period of low interest rates has allowed global asset prices to appreciate. While we think many of the gains are warranted, low cost of debt has also introduced elements of speculative activity across various asset classes, pushing valuation to unreasonable levels in some cases. This momentum-driven market came to a screeching halt on the morning of Friday February 2, when the long absent sibling of economic growth reappeared: inflation. Prompted by a cyclically low unemployment rate, rising demand for workers, and tax cuts, U.S. wage inflation for January was reported at 2.9% YoY, the strongest level in nine years. As wage inflation is typically associated with impending consumer price inflation, markets abruptly woke to the prospect that central banks may need to raise interest rates faster than previously expected to moderate the pace of inflation.

History has shown that investors need not necessarily fear a rising interest rate environment. Since central banks raise interest rates due to a return of economic prosperity and stability, rising interest rates and rising stock markets can co-exist. While this co-existence has been observed in many previous economic cycles, it typically occurs during the first stages of the rate hike cycle when inflation remains low. Eventually, the cumulative effect of higher interest rates begins to slow economic activity and investors typically begin a cyclical migration from risky assets to less risky ones; otherwise known as adjusting asset allocation.

With inflation prospects as the trigger, we attribute some of the market volatility seen in recent days to a recalibration of interest rate expectations and ensuing asset allocation adjustments. We also think that recent volatility has been exaggerated as complacent leveraged bets by some investors are unwound. As we are constantly vigilant for signs of an inflection point in the macro economic outlook, we don’t think recent volatility is foreshadowing an imminent economic slowdown. Among various economic data points we are monitoring, ongoing strength in the U.S. labour market remains supportive for equity market sentiment (exhibit 2). Indeed, based on all currently available information, we don’t expect global macro conditions to reverse until mid-2019 or early-2020. As such, we view recent volatility as an opportunity to buy at more attractive valuations. With a conservatively positioned asset allocation of 60%/40% equity/fixed income in our discretionary model, we expect to modestly raise our equity exposure as markets stabilize.

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