The market’s focus on two words (“next meeting”) in the Federal Open Market Committee’s recent announcement shook markets, sending both the U.S. dollar and U.S. yields higher. Yes, perhaps the Fed does indeed want to raise rates, but they have certainly been cautious in confirming that the data warrants that approach. With two employment reports between now and the next FOMC meeting, we anticipate that if those reports are benign, “liftoff ” will probably take place in December.
But then again, maybe there will still be a reason to hold off. The Fed has consistently found reasons to remain where they are and it is reasonable to think that they can likely find whatever justification they need to support their decision in December.
The FOMC has shied away from realizing their long-held alert of a pending rate rise over the last couple of meetings. The hawk camp has viewed zero-bound rates as long past any sense of appropriateness given that the unemployment rate hovers around 5%. In contrast, doves have feared market turbulence and remind us that a few headwinds are already in place: a stronger U.S. dollar, lower financial asset prices, wider credit spreads, and a lack of compelling inflation. Overall, the majority has viewed things as not yet quite right enough, putting a whole new slant on the Goldilocks story.
In our view, determining market directionality today has a lot to do with separating the signal from the noise. To us, identifying the most significant economic and market influences, when the noise is all anyone wants to discuss, is the hard part.
Right now, the question on everyone’s mind seems to be about what’s going to happen with interest rates. But we are asking ourselves, beyond the symbolism of finally moving away from the financial crisis, does a 25 basis point shift by the Fed really make a tremendous difference? Markets may view that they have been pushed and pulled around by a changing sense of what the Fed may or may not do and when. Yet more likely, we believe the larger market volatility we have witnessed reflects a changing world, where economic growth engines that have been manufacturing and commodity-based are fading (and so is the growth at companies that have been leveraged to these things). We believe we are in the midst of adjusting to the new reality of technology-driven and service-based economic lives.
Though their long-tailed impacts render them somewhat harder to describe, we believe there are two market drivers exhibiting considerable influence, and the first is technology. We think there seems to be a good amount of noise in the market lately about the decline in worker productivity. Its absence has been one of the mysteries of the economy’s post-2008 growth. Yet our hypothesis is that a more complete picture might be that technology is pushing inflation lower and also influencing a relative decline in world trade. As the manufacturing ecosystem shifts increasingly to services, prices for commodities and manufactured goods are declining. Technology is creating greater efficiency at a lower cost, and therefore having an enormous impact on inflation.
Productivity Leveling Off 
But inflation itself can be a distorted concept and a discussion of it as “one number” misses important considerations of underlying contributions. The third quarter core PCE deflator, 1.3%, is certainly of limited threat to a Fed that explicitly wishes the number were higher. The strong U.S. dollar has helped domestically, as food and energy prices have remained constrained for the U.S. consumer. We also have to acknowledge that consumption (final demand) is solid – not booming, but solid. Compared with much of the world, the U.S. is adjusting further and faster. The boosts to the consumer have been impressive and we believe practically all the weakness is in prices. We anticipate this factor probably does not recede.
The other point is that demographics are changing economies. While China’s recent announcement ending the “one child per family” rule cuts against this, the aging of the population globally reduces growth. It is difficult to stimulate aggregate demand in an old world, and at the same time, it’s difficult to provide the asset returns that they desire. Certainly, a good portion of the older population is currently working, producing income, and consuming, but trends are against that. The elderly have a high demand for fixed income vehicles and the demand for investment assets is unprecedented. There are currently crowded positions in short-term fixed income securities with zero-bound returns. Additionally, with congested risk-taking trades, the resultant returns are simply lower.
Overall, we believe technological advances and an aging population will have a far greater impact on market prices than the output of the FOMC’s December meeting; these impacts are just a bit harder to grapple with and the stories do not fit into a single sound bite.
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