I'll offer a few quick thoughts on what is happening. The global equity sell-off can be attributed to two main factors. These are slowing global growth and Federal Reserve policy. PMI and GDP data from Europe and China has been poor. China reports the next PMI and GDP data in early January 2019. My expectation is a manufacturing contraction reading below 50 and lower growth. Japan's economy contracted in third quarter. Emerging markets have experienced pressure throughout the year on their currencies and equities with the MSCI Emerging Markets Index down 18% year-to-date.
There is a sense in the market that the global reflation theme of 2016 and synchronized global growth of 2017 proved to be a false dawn. Remember, in late 2015 and January 2016 markets were in a state of turbulence. Oil prices were hitting new lows, the Eurozone economy was underperforming, speculative pressure on the yuan and Chinese financial stress was high. Federal Reserve tightening concerns were also at the forefront of the market. These issues seem to be coming back and perhaps more strongly.
What happened that made these issues go away and then suddenly re-appear? The answer is the stance of U.S. monetary policy. The Federal Reserve under Yellen with a weaker U.S. economy than currently was decidedly more dovish. When Yellen paused throughout 2016 in response to financial conditions, global concerns and sub-par U.S. economic data, everything was alleviated. Powell is facing a different situation where U.S. unemployment is below both the natural and non-inflation-accelerating rate. The inflation goal is essentially met. Growth is above trend and government deficits have widened providing stimulus to the economy. Powell is likely inclined to continue tightening raising rates two or three times in 2019 while leaving the balance sheet unwind (quantitative tightening) on autopilot at $50 billion in securities per month.
I believe this is the right decision. If the Fed were to pause for a considerable time, the risk of falling behind the curve on inflation is too great. These are not normal times. The Federal Reserve in response to the global financial crisis in 08, embarked on several years of quantitative easing (QE) and has injected trillions in liquidity into the banking system providing massive potential for an excessive credit expansion leading to inflationary overshoot.
The Federal Reserve is very cognizant of this risk and well aware of the 1970's inflationary episode, which is widely attributed to holding rates too low for too long in the 1960's. Many are claiming continuing to tighten risks a policy mistake through a premature recession. I take the opposite and somewhat unpopular opinion, that not tightening would be the real policy mistake. Moving rates to neutral or slightly above risks little harm to the real, core U.S. economy though financial markets will react negatively. Tightening now will prolong the expansion by avoiding a repeat of the Volcker recessions, where Fed Chair, Paul Volcker, had to respond to inflationary pressures by raising interest rates quickly and drastically above neutral, sending the economy into a recession. By continuing to tighten, global risk and growth assets, such as oil, copper, and equities may decline. This tightening and growth asset decline is not necessarily unhealthy as it keeps inflation and inflationary expectations contained and avoids an upside breakout that requires significantly higher rates or financial excesses that then burst.
I remain optimistic on the U.S. dollar and DXY index. The USD is one of the few assets with positive YTD returns in 2018. I think Europe is sitting in a situation similar to where the U.S. was a couple years ago in 2016. I believe an extended pause from the ECB on rates is likely as Eurozone data continues to underperform, the equity sell-off continues and global growth (specifically China) decelerates. This will weigh on the EUR/USD, the largest component of the DXY index.
Disclosure: I am/we are short FCX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.