Beset with low rates, slow growth and a new US president who wants a significant shift in policy, the Federal Reserve faces one of the most uncertain periods in its 104-year history. What could a changing Fed mean for investors?
Changes afoot at the Fed
The election of President Donald Trump has already had significant implications for many US institutions – from the Supreme Court to the Board of Education – and the Federal Reserve is next in line. A complete revamping of the country’s central bank will start to play out over the next 12 to 15 months.
During that time, the Federal Reserve Board will likely welcome five or six new governors, implement new approaches to monetary policy, take a looser regulatory stance, reduce its portfolio of assets and potentially encounter unprecedented oversight by the executive branch. Taken together, these shifts in direction will provide an important reminder that while the US central bank is “independent within government”, as it is often described, it is not “independent from government”.
Existing legislation empowers Mr Trump to appoint Fed governors who favour policy adjustments that are in line with his administration’s goals – and he will certainly have several opportunities to do so. By stacking the Fed’s Board with like-minded governors, Mr Trump can weaken the Treasury-Federal Reserve Accord of 1951, which freed the central bank to formulate monetary policy regardless of the wishes of the president.
At the same time, the Fed’s independence from political interference will not be entirely eroded. The Fed will likely take symbolic actions that add to the transparency of its operations, and unless new legislation is enacted, there should not be meaningful changes to the structure of the Fed system.
Investment implications of the new Fed
- Faster and higher interest-rate hikes. New Fed governors will likely resemble other Trump administration officials – for example, business executives who dislike excessive regulation. We also expect the next Fed Chair to favour a strict, rules-based approach to monetary policy formulation and implementation. This is a marked departure from the view of current Fed Chair Janet Yellen, who vigorously opposes such an approach. Given that most of the current 17 members of the Federal Open Market Committee believe US interest rates are too low to stimulate enough real economic activity, a newly revamped Fed may elevate rates as quickly as economic conditions allow. Rules-based models suggest that the FOMC could feasibly raise interest rates to 4 per cent soon. Investors may want to consider factoring this forecast into their asset allocations – particularly given that many bonds lose value as interest rates rise.
- A shrinking Fed balance sheet with limited market disruption. The weighted average maturity of the Fed’s balance sheet has shrunk considerably since its peak in January 2013. Although it is unlikely that the Fed’s portfolio will be reduced to its pre-financial crisis levels, we expect the Fed will begin unwinding its positions later this year as the federal funds rate approaches its target level. Recent hints by FOMC members suggest that they will reduce holdings of both Treasuries and mortgage-backed securities. Investors may be reassured by the fact that because the Fed has preannounced its intentions, it is unlikely that these portfolio reductions will significantly disrupt the markets or have an outsize effect on interest rates.
- Reduced regulatory burdens to spur growth. The resignation of Governor Daniel Tarullo, the Fed’s head of supervision and regulation, enables President Trump to nominate a successor who will relax enforcement of existing regulations, roll back others and, perhaps, guide the withdrawal of the US from some international banking standards. Look for the Fed to either withdraw from Basel IV capital standards negotiations or, at least, to attempt to impose US-favoured rules. Other international standards covering leverage, solvency and liquidity could be modified or put at risk. This may mean that small regional and community banks can look forward to diminished regulatory burdens. This could give them more scope to lend money to local businesses, which could in turn spur some economic growth.
For more information, read “The End of the Fed as We Know It?” on allianzgi.com
With his victory as France's new president-elect, Emmanuel Macron can celebrate – for now. Much depends on whether he can secure a parliamentary majority in June. Nevertheless, Macron’s win helps investors see the more positive side to the European story.
EU breathes a sigh of relief
With the election of Emmanuel Macron as France's next president, the European Union breathes a sigh of relief, although the results of the National Assembly election in June will have a significant bearing on his ability to accomplish his political agenda. Yet even with this resolution in France, some degree of political uncertainty
Some degree of political uncertainty will persist as Europe's ongoing 'super cycle' of elections continues
Mr. Macron's victory means France and the EU should be able to move past some of the more divisive issues raised during this presidential race, and investors can now start to focus on the positive economic story emerging in Europe:
- Mr. Macron is pro-euro and pro-European Union, and his victory is clearly a win for the EU – though it could make Brexit negotiations more difficult for the UK if France and Germany become more tightly allied.
- Mr. Macron's victory decreases the possibility of a "Frexit" from the EU and should prevent NATO from being further undermined.
- Ms. Le Pen's loss means a setback for the forces of nationalism in France, though her National Front party has developed a formidable amount of support. Anti-EU feelings can still resurface, particularly given that Mr. Macron remains a conventional, pro-establishment politician.
Two scenarios for Mr. Macron
Mr. Macron will need to cooperate closely with the incoming class of French legislators to have any hope of enacting significant policy changes.
As such, we see two scenarios to consider after June's elections:
Mr. Macron is pro-euro and pro-European Union, and his victory is clearly a win for the EU
- President Macron's party does not gain a clear parliamentary majority. Unlike Germany, France has less experience forming political coalitions, which could limit Mr. Macron's ability to pass reforms. Under this scenario, which we believe is more likely, the markets would be uncertain about his room to maneuver.
- President Macron's party wins a parliamentary majority. As illustrated by the market's reaction immediately after the first round of presidential elections, this scenario should be bullish for euro-area risk assets, such as equities and bonds from the peripheral areas of the euro zone.
In general, Mr. Macron's victory and the accompanying rejection of euro-phobia should reduce some of the market's worries about political risks. This should help investors concentrate on the more positive economic side to the European story.
- Macroeconomic indicators. Unemployment numbers look much better than they did three years ago, and many economic indicators show positive signs. For example, recent purchasing managers index numbers show steadily improving manufacturing output in the euro zone.
- Interest rates. Despite some investors looking for higher rates in the immediate future, we don't expect to see a real change for at least 6-12 months. Indeed, we also don't expect the European Central Bank to begin tapering until 2018.
Many euro zone economic indicators, such as manufacturing output, are showing positive signs
- The euro. The currency is likely to strengthen on the back of a better political outlook as well as better cyclical data and expectations of tapering in due course.
- Equities. There is a good chance that political risk will be priced out further. Based on our analysis, European equities – which have shown higher revenues and stronger order books and should continue to outperform global equities – will have further upside potential as political uncertainty declines.
- Fixed income. Our outlook for French government bonds is slightly positive. If Mr. Macron finds parliamentary support, we expect tighter credit spreads, a strong reduction of French-specific risk and tighter spreads in the euro-zone periphery; without it, we expect a mild risk appetite in fixed-income markets, with some event-driven spikes of volatility.
What's next for France – and Europe
While political developments make headlines that influence the financial markets, cyclical forces remain key drivers of performance. As long as the cyclical backdrop is positive, we should be in a good environment for risk assets – provided we don't get a clearly negative signal from the political realm. The outlook for monetary policy, both in the US and in the euro area, will also continue to be a key determinant for markets.
Mr. Macron's victory brings with it the potential for a new and constructive agenda between France and Germany
But politics continue to dominate much of the discussion for policymakers, voters and investors alike. We now expect the markets to turn some of their focus to Italy – the elephant in the room. It has an economy with weak growth rates, a weak banking sector and a governing party at risk of splitting up. If Italy does not hold a snap election this year, a regular election will be held in the spring of 2018. The risk of anti-European forces coming to power at either juncture is reasonably high.
Some degree of political uncertainty will persist as Europe's ongoing 'super cycle' of elections continues. Overall, however, Mr. Macron's victory brings with it the potential for a new and constructive agenda to be formed between France and Germany. This could help Europe move closer toward integration, and provide further reassurance for investors.