Don’t fret the rate rise: Party like it’s 1995

To make it simple, I’ll state my conclusion upfront. My outlook for 2020, or at least the first half of 2020, is quite sanguine. I believe the performance of risk assets is likely to be quite decent for the following reasons:

1. The global economy is reaccelerating, albeit from a low level to a modest level.
2. The Federal Reserve (Fed) has moved off the tightening bandwagon.
3. Other central banks are maintaining policy support.
4. Both the Fed and European Central Bank are expanding their balance sheets.
5. A US-China trade deal is almost in hand (at least no further exacerbation of trade issues).
6. The dollar has weakened, which means better earnings comparisons for US multinationals.

To be sure, we are discounting a lot of the turnaround in current market prices and sentiment today. Nevertheless, given the reacceleration in growth and earnings, there is still some decent upside to the markets.

In that regard, the turnaround is almost a mirror image of a similar episode in the mid-1990s, when the Fed stopped tightening after a disastrous 1994 and cut rates. That extended the cycle until the tech bubble burst.  Interest rates were range-bound for a long period, and most of us remember those years quite fondly.

Today, the fundamental picture of the global economy is already improving. A combination of the factors below should help overall growth rates improve but only modestly:

1. Easing of global financial conditions, which is already reviving credit growth.
2. The manufacturing sector hitting a low and starting to improve with inventory liquidation and the bottoming out of the global auto cycle and a trade agreement (or at least no further exacerbation of the trade issues).
3. Relative stability in non-manufacturing sectors supported by high employment levels and modest wage growth.
4. An expected improvement in global trade driven by a reacceleration in domestic market growth and a large US fiscal deficit.

The improvements in global growth, and consequently on the earnings front, means that year-over-year comparisons for 2020 earnings growth should look better than 2019. Nominal growth will lead to modest earnings growth, and the tax-cut-related aberrations in 2018-19 comparisons should soon get phased out. Earnings are not going to grow gangbusters, but they will likely grow.

While the fundamental outlook is improving, investors remain cautious.

One worry that seems to have surfaced lately is the potential for rates to rise rapidly.

While that is a better problem to be worrying about than a recession that never arrived, I believe this concern is equally misplaced.

Remember, Jay Powell’s announcement that the Fed will not consider raising rates until they see persistent inflation ensures that the Fed policy—and the front end of the curve—is very much anchored.

Furthermore, I can argue that the current monetary policy regime— like it or not, the first principal component of any market cycle—is in a significantly better place than the 1990s for two very important reasons:

1. The lack of actual inflation provides a now non-doctrinaire Fed with a lot more policy flexibility.
2. The likelihood that the rate term premiums stay the same is far more subdued because of low inflation expectations and the associated risk premium, and low overall growth rates keeping real yield term premiums low.

In other words, if the front-end rates are anchored, rates at the long end are unlikely to rise much because of low growth, low real rates, low actual inflation, low inflation expectations, and low real rate risk premium. The 10-year rates, which are close to 2% today, will, in all likelihood, cap out around 2.25 to 2.5%. The overall interest rate volatility backdrop, then, is likely to be meaningfully better than the mid-1990s, when at various points, rates were almost 150 bps higher than their early 1995 lows.

But there is a caveat. If you did a word count on “modest” in the above paragraphs, it might be off the charts. It’s bad writing, but a reality we cannot escape. Everything is improving but only marginally. And therefore, our expectations for asset price performance should also be modest. This is still a low growth world, and asset prices are on the high side, and the likelihood that they go up a lot from here is quite low, in my opinion.

The bottom line, in my view, is that the first half of 2020 is perfectly set up for asset prices to rise with less volatility than usual as both expected and realized interest rate volatility is likely to be lower. It’s like 1995 all over again, but even better.

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The opinions expressed are those of the author as of November 13, 2019, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.

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