“Relax” – Frankie Goes to Hollywood, 1984

“Relax” – Frankie Goes to Hollywood, 1984

This week, for the first time since December 1995, the Federal Reserve will almost certainly ease its monetary policy despite the US economy being far from recession. Consequently, financial markets are divided on the extent and the duration of the upcoming Fed easing. In this weekly note, we analyse previous Fed easing cycles in order to assess the likely impact for financial assets and the global economy. We believe that central banks are ready to do “whatever it takes” to reduce the risk of recession, firstly by lowering short-term rates and secondly, if needed, by restarting quantitative easing. So, sit back and relax, central banks will save markets once again.

What’s Next?

Transparency vs history

In 1987, speaking to a Senate Committee, the then Fed president, Alan Greenspan, spoke the famous sentence: “If I seem unduly clear to you, you must have misunderstood what I said”. More than three decades later, the situation has dramatically changed. Central banks around the world have increased their efforts to be transparent by enhancing communication about policy decisions and their assumptions about the economy. Now, with clear forward-looking guidance on policy, dot projections and regular reviews of monetary policy strategy, tools and communication, the stance of central banks is well known and understood by financial markets.

Currently, the message appears to be crystal clear: significant easing is on the horizon. Since the beginning of the year, central banks in New Zealand and Australia have cut their rates. The trend is similar in the emerging world, with cuts in India, Malaysia and Russia. Europe, Canada, Mexico and the US are all set to follow, as reflected by the forward curves for these countries.

Based on recent Fed speeches, it appears almost certain that they will cut rates in 2019. Over the last six months, this transparency on the monetary policy outlook has helped markets to stabilise after the turmoil of last year. As a result, uncertainty is very low ahead of this week’s meeting. We expect a 25 bps cut this week and then a second, similar cut before the end of the year. Currently, the market is forecasting an easing of 100 bps over the next twelve months.

Compared to what has happened in the past, this pricing is either too large if the US economy continues to grow at or slightly below potential, or too small if recession risks increase markedly in the coming months.

Since 1990, there have been five easing cycles in the US. Apart from in 1998, markets have consistently underestimated the amplitude of the Fed action. In our analysis, we have compared six-month expectations, as measured by the Fed Fund curve at the starting date of the easing cycle, with the realised six-month change in the Fed Fund rates. In 1989, markets expected 100 bps of cuts and the Fed delivered 150 bps. In 1995, expectations were for 50 bps and the Fed eased by 75 bps. In 1998, expectations matched the 75 bps of easing delivered by the Fed.

In 2000, markets priced in only 50 bps of cuts against actual cuts of 250 bps within six months. Finally, in 2007, as in 2000, Fed easing was large and quick with 225 bps of easing within six months versus the 75 bps expected. Conclusion: financial markets seem blind when they have to evaluate the depth of the economic slowdown and the speed of the downward dynamic. Therefore, they tend to underestimate the size of central bank action.

Risk scenario is “Dovishness” not “Hawkishness”

At this stage of the US cycle, our proprietary US GDP Nowcaster, which tracks the US economy in real time, does not point to any risk of recession in the coming months. However, we are convinced that the Fed has all the tools to act if necessary and will not need to wait for symptoms of recession to activate significant levels of easing. In fact, the Fed has room to lower rates and then to steepen the curve because they are the only central bank to have normalised its monetary policy over the last four years. With its current balance sheet at 2013 levels, the Fed also has room to expand its balance sheet.

But why would the Fed ease more than market expectations if recession risk remains low? We believe that the Fed is more concerned about the current inflation dynamic rather than the economic outlook. In their latest monetary policy report submitted to Congress, the Fed highlighted five monetary policy rules (https://www.federalreserve.gov/monetarypolicy/2019-07-mpr-part2.htm). Four of the five rules concern the difference between the sustainable long-term rate of unemployment and the current unemployment rate, and the difference between recent inflation and the FOMC’s longer-run objective. The fifth one, the price-level rule, takes into consideration the deviation of inflation from the long-run objective in earlier periods as well as the current period. The other rules do not consider the past misses of the inflation objective. This price-level targeting rule was favoured by former Fed chairman Ben Bernanke to face effective lower bound (ELB) challenges in 2017. In the latest report, this rule is the only one below the current Fed Fund rate. Moreover, the recommended rates of the price level rule are closer to 0 than to 225 bps below current rates, roughly the size of the six month easing cycle in 2000 and 2007.

“Bad is good” or “bad becomes bad”

Anticipating large moves from central banks means forecasting a high risk of recession. Historically, such a context has not been favourable for growth-oriented assets and they have underperformed government bonds. Since 1989, in the six months following the first Fed cut, US equities have delivered an average return of 5%. However, the dispersion has been large, with a 28% return in 1998 and a 13% loss in 2007.

So, how will the market react this time? We believe that the global accommodative stance from central banks should be supportive for carry strategies. Pro-active central bank easing lowers the risk of recession, leading to a reduced probability of credit default and reduced volatility. A combination of a stable economic cycle and low realised volatility for financial assets improves the risk/reward of being exposed to risk premia and encourages risk taking. This limits the downside, which pushes realised volatility lower, creating a positive loop.

But where could things go wrong? If central banks do not deliver. Has this ever happened? Not since 2008 and the implementation of unconventional monetary policy. As defined recently by the NY Fed President, the new normal monetary policy framework is like a vaccination: “It’s better to take preventative measures than to wait for disaster to unfold.” So sit back and relax.


Frankie Goes to Hollywood

Strategy Behaviour

Our medium-term views remain cautious, and we prefer to get exposure to growth via high yield corporate credit. We are also complementing our equity exposure with options to protect the portfolio in the case of equity drawdowns.

Performance Review

Over the month of July thus far, the Uni-Global – Cross Asset Navigator fund is up 1.30% versus 1.55% for the MSCI AC World Index and 0.53% for the Barclays Global Aggregate (USD hedged). Year-to-date, the Uni-Global – Cross Asset Navigator has returned 8.52% versus 18.03% for the MSCI AC World index, while the Barclays Global Aggregate (USD hedged) index is up 6.57%.

Unigestion Nowcasting

World Growth Nowcaster

World Growth Nowcaster

World Inflation Nowcaster

World Inflation Nowcaster

Market Stress Nowcaster

Market Stress Nowcaster

Weekly Change

  • Our world Growth Nowcaster remained unchanged this week, as the slight improvement in the US situation was offset by European and Japanese data.
  • Our world Inflation Nowcaster decreased further this week, mainly driven by continued disinflationary prospects in the US.
  • Market stress decreased this week, as credit spreads contracted.

Sources: Unigestion. Bloomberg, as of 29 July 2019.

Navigator Fund Performance

Performance, net of fees 2018 2017 2016 2015
Navigator (inception 15 December 2014) -3.6% 10.6% 4.4% -2.2%

Past performance is no guide to the future, the value of investments can fall as well as rise, there is no guarantee that your initial investment will be returned.


Important Information

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Uni-Global – Cross Asset Navigator is a compartment of the Luxembourg Uni-Global SICAV Part I, UCITS IV compliant. This compartment is currently authorised for distribution in Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Norway, Spain, UK, Sweden, and Switzerland. In Italy, this compartment can be offered only to qualified investors within the meaning of art.100 D. Leg. 58/1998. Its shares may not be offered or distributed in any country where such offer or distribution would be prohibited by law.

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All investors must obtain and carefully read the prospectus which contains additional information needed to evaluate the potential investment and provides important disclosures regarding risks, fees and expenses. Unless otherwise stated performance is shown net of fees in USD and does not include the commission and fees charged at the time of subscribing for or redeeming shares.

Unigestion UK, which is authorised and regulated by the UK Financial Conduct Authority, has issued this document. Unigestion SA authorised and regulated by the Swiss FINMA. Unigestion Asset Management (France) S.A. authorised and regulated by the French Autorité des Marchés Financiers. Unigestion Asia Pte Limited authorised and regulated by the Monetary Authority of Singapore. Performance source: Unigestion, Bloomberg, Morningstar. Performance is shown on an annualised basis unless otherwise stated and is based on Uni Global – Cross Asset Navigator RA-USD net of fees with data from 15 December 2014 to 10 June 2019.