Eyes On The Pressure Gauges
By Erik Knutzen
As the economic machine speeds up, where on the dashboard do we look for pressure?
The market certainly blew off some steam in the days after my last, cautionary Perspective on inflation risks. It felt like an important moment. If the economy is a machine, financial markets are its pressure-release valves and market levels are its pressure gauges. When markets let off steam, it's a sign that eyes have turned to those gauges, watching for needles moving into the red.
In our most recent Asset Allocation Committee (AAC) Outlook, we anticipated that the transition into a new environment of rising inflation expectations, rising rates and faster growth would take us into more normal volatility conditions. The turbulence we got a month ago came earlier than we expected, but it was a characteristic response to late-cycle inflationary growth. Risky assets have bounced back and implied volatility has settled to historically normal levels of around 15-20, neither as high as in early February nor as low as through 2017. The risk of recession this year appears remote, and investors are still buying the dips rather than becoming defensive.
But now, unlike last year, all eyes are on the dashboard.
Three Key Pressure Gauges
I have been on the road a lot this year, from the U.S. Great Lakes to Japan to Europe, and investors have nearly always asked me the same question: Which gauges are we watching most closely, and where do we think the red zones are?
Of course, our dashboard is crammed with instruments monitoring market prices, equity valuations, corporate earnings and a raft of macroeconomic releases. Three gauges are particularly important to us right now, however.
The trigger for the sell-off a month ago was an unexpectedly strong U.S. wage-growth print, which followed an already substantial rise in bond-market breakeven inflation rates. The Inflation Expectations Gauge is front and center, then: Once the 10-year U.S. breakeven rate breaks through 2.5%, things start to get interesting, and it could cause the Federal Reserve to adjust its policy; but our research indicates that inflation has had to rise above 3% before it has seriously affected important market relationships.
The Interest Rates Gauge is right next door. How high can rates go before the market decides they have overshot? We think 3.25% for the 10-year U.S. Treasury yield is tolerable. A rapid rise to 3.5%, however, and stress levels in credit markets could rise, valuations in equity markets may have to be revised, and the response could bring forward the end of the cycle.
Our third key gauge monitors U.S. dollar exchange rates. If the dollar swoons further, past 1.05 against the Japanese yen or 1.30 against the euro, that would pose a significant headwind to corporate earnings in Japan and Europe, potentially eliciting disruptive monetary policy changes in Tokyo and Frankfurt. In the less likely event that the dollar rapidly strengthens, when does it start to weigh on commodity prices or export-driven emerging economies that owe a lot of dollar-denominated debt?
A Complex Machine
At Neuberger Berman, we see no obvious reason why this mature phase of the current economic cycle should not persist for some months, perhaps into 2020. All we need is well-behaved inflation, a predictable pattern of modestly rising interest rates and an orderly unwind of central bank balance sheets.
Markets are seldom orderly, however, and the economy is a very complex machine. We expect it to run hotter and faster this year, and that is why investors are now watching its pressure gauges more intently - for signs that it is running too hot or too fast. If and when those needles move into the red, it may be time to adopt a more defensive portfolio position to make sure we are prepared for when the market really lets off some steam.
In Case You Missed It
- U.S. New Home Sales: -7.8% to SAAR of 593,000 units in January
- U.S. Durable Goods Orders: -3.7% in January (excluding transportation, durable goods orders decreased 0.3%)
- Case-Shiller Home Prices: December home prices increased 0.2% month-over-month and increased 6.3% year-over-year (NSA); +0.6% month-over-month (SA)
- U.S. Consumer Confidence: +6.5 to 130.8 in February
- U.S. 4Q 2017 GDP (second estimate): +2.5% annualized rate
- U.S. Personal Income and Outlays: Personal spending increased 0.2%, income increased 0.4% and the savings rate increased to 3.2% in January
- ISM Manufacturing Index: +1.7 to 60.8 in February
- Eurozone Producer Price Index: +0.4% in January month-over-month and +1.5% year-over-year
What to Watch For
- Monday, 3/5:
- ISM Non-Manufacturing Index
- Tuesday, 3/6:
- Eurozone Purchasing Managers Index
- Wednesday, 3/7:
- Eurozone 4Q17 GDP
- Japan 4Q17 GDP
- Thursday, 3/8:
- Eurozone Central Bank Policy Meeting
- Friday, 3/9:
- U.S. Employment Report
- Bank of Japan Policy Meeting
- Andrew White, Investment Strategy Group
Statistics on the Current State of the Market - as of March 2, 2018
|S&P 500 Index||-2.0%||-0.8%||1.0%|
|Russell 1000 Index||-1.9%||-0.7%||0.9%|
|Russell 1000 Growth Index||-1.8%||-0.8%||3.5%|
|Russell 1000 Value Index||-1.9%||-0.6%||-1.7%|
|Russell 2000 Index||-1.0%||1.4%||0.0%|
|MSCI World Index||-2.3%||-1.3%||-0.3%|
|MSCI EAFE Index||-2.9%||-2.2%||-2.0%|
|MSCI Emerging Markets Index||-2.8%||-1.1%||2.2%|
|STOXX Europe 600||-2.6%||-1.4%||-2.0%|
|FTSE 100 Index||-2.3%||-2.1%||-7.3%|
|CSI 300 Index||-1.3%||-0.2%||-0.3%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.0%||0.1%||-0.3%|
|Citigroup 10-Year Treasury Index||0.2%||0.1%||-3.6%|
|Bloomberg Barclays Municipal Bond Index||0.1%||0.1%||-1.4%|
|Bloomberg Barclays US Aggregate Bond Index||0.0%||0.0%||-2.1%|
|Bloomberg Barclays Global Aggregate Index||0.2%||0.4%||0.7%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||0.0%||-0.1%||1.0%|
|ICE BofA Merrill Lynch U.S. High Yield Index||-0.3%||-0.5%||-0.8%|
|ICE BofA Merrill Lynch Global High Yield Index||-0.2%||-0.2%||-0.2%|
|JP Morgan EMBI Global Diversified Index||0.0%||-0.2%||-2.2%|
|JP Morgan GBI-EM Global Diversified Index||-1.0%||-0.2%||3.2%|
|U.S. Dollar per British Pounds||-1.4%||-0.1%||1.8%|
|U.S. Dollar per Euro||0.1%||0.9%||2.5%|
|U.S. Dollar per Japanese Yen||1.1%||1.2%||6.8%|
|Real & Alternative Assets|
|Alerian MLP Index||-2.7%||0.2%||-4.3%|
|FTSE EPRA/NAREIT North America Index||-1.8%||0.3%||-10.5%|
|FTSE EPRA/NAREIT Global Index||-1.8%||0.0%||-5.6%|
|Bloomberg Commodity Index||-0.6%||0.0%||0.2%|
|Gold (NYM $/ozt) Continuous Future||-0.5%||0.4%||1.1%|
|Crude Oil (NYM $/bbl) Continuous Future||-3.6%||-0.6%||1.4%|
Source: FactSet, Neuberger Berman.
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