Perspective from the Franklin Templeton Fixed Income Group®
IN THIS ISSUE:
- United States Prepares for Interest-Rate Hikes
- But Much of the World Is Still in Monetary Easing Mode
- European Outlook
United States Prepares for Interest-Rate Hikes
The US economy remains in fine form, in our view. Job creation has remained very strong, with gains in nonfarm payrolls coming in at a three-month average of 288,000 through February. In other words, US firms added almost 900,000 net new jobs in the past three months, helping reduce the unemployment rate to 5.5%. With the increasing number of people employed, aggregate private payrolls have increased at a rapid pace of 5.35% year-on-year at end-February, according to the Bureau of Labor Statistics. And there are now even signs that per capita wage inflation may finally be kicking in. Wage earners’ bargaining power has remained weak, with hourly earnings up just 2% in February, compared with a year earlier. However, combined with the rising value of their homes and equity portfolios, in broad terms, as well as the steep drop in oil prices, many Americans’ personal finances have undoubtedly improved. This increase in aggregate wages has fed into robust readings for consumer spending—about two-thirds of economic activity—which expanded at an annual rate of 4.2% in the final three months of 2014.
But some economic data points have flagged a bit in recent weeks in the United States, pointing to good rather than exceptional growth prospects. Gross domestic product (GDP) grew by 2.4% in 2014 overall, but in the fourth quarter, growth came in at just 2.2%—well off the 5% pace seen in the third quarter. The Institute for Supply Management’s purchasing managers index showed a slowing in manufacturing expansion for the fourth consecutive month in February, while auto sales and construction spending slowed in January—perhaps in part because of severe weather in many parts of the country. A harsh winter may also explain why US consumer sentiment fell from January’s 11-year high in February.
The fall in oil prices has impacted consumer price inflation, which fell sharply in January. However, there appears to be little reason to worry about deflation in the United States, as nominal interest rates are very low and very flexible. Aggregate demand in the United States has remained robust, and we believe the fall in oil prices that has led to negative inflation is positive for the economy overall. Besides, the large oil price declines seem to be over, having recently shown signs of bottoming out. With the deflationary impact of falling oil prices wearing off, and with wages and employment rising, we would fully expect headline inflation to rise again as the year progresses.
Additionally, core prices excluding energy and food have been much more stable: The core consumer price index came in at an annual rate of 1.6% in January, while core personal consumer expenditures—which the US Federal Reserve (Fed) refers to in its monetary policy deliberations—stood at an annual rate of 1.3% in the same month. When viewed alongside wage and job growth, the short-term drop in consumer prices does not signal to us any sign of a renewed recession, and may not deflect the Fed from gradually normalizing base interest rates from at or close to zero in the months ahead.
Market expectations for the federal funds rate—the overnight rate at which a depository institution lends funds maintained at the Fed to another depository institution—have remained much lower than Fed policymakers’ median estimate for rates through end-2016, which appears to reflect a belief that the economic recovery is not robust and that deflation remains a threat. This is not our view. We think the US economy is currently in a kind of “goldilocks” scenario, with positive economic growth and low inflation. The financial sector has substantially healed its wounds since 2009, private debts are being reduced, and low oil prices are helping many households and companies alike. However, with the base effects of lower energy prices fading, the labor market tightening, and economic growth the order of the day, in our view, we should see inflation pick up later this year. Indeed, an increase in expectations that inflation is likely to rise has been priced into market valuations.
At the same time, 10-year benchmark US Treasury yields, though they have started to rise, remain low, still benefiting from strong foreign buying on the back of ultra-low yields in Europe and Japan, the lingering effects of the distortions caused by the Fed’s last bond-buying program (which ended in October 2014), and a relatively benign view of the likely pace and size of short-term interest-rate hikes by the Fed. Even though the US economy continues to grow, these factors are containing the rise in benchmark bond yields for the moment.
But Much of the World Is Still in Monetary Easing Mode
The end of February and beginning of March saw central banks in both China and India lower benchmark rates. Indeed, with inflation rates easing throughout many developing countries, as well as throughout the developed world thanks to falling energy prices, monetary easing remains the order of the day, except in some countries facing unique challenges such as Russia and Brazil. Before these developments in China and India, Poland’s central bank cut its benchmark rate by a deeper-than-expected 50 basis points (0.50%) to 1.50%, a record low. Like other non-eurozone countries in Europe, Poland is seeking to limit upward pressure on its national currency ahead of the European Central Bank’s (ECB’s) quantitative easing (QE) initiative, which began in early March. Slippage in fourth-quarter growth in Australia is seen as likely setting the stage for further cuts to interest rates there, following the 25 basis-point cut (0.25%) enacted by the Reserve Bank of Australia in early February. Disinflation has been providing cover for all these central banks’ actions.
However, it is perhaps more interesting to consider rate cuts in China and India as simply corollaries to broader reform moves in both countries. In India’s annual union budget, unveiled on March 1, the government of Prime Minister Narendra Modi gave itself an extra year to hit its 3% budget deficit target, deciding instead to spend money on upgrading infrastructure. The government also promised improved efficiency in social welfare programs and introduced a meaningful cut in corporate tax. The Reserve Bank of India’s 25 basis-point cut (0.25%)—announced just after the unveiling of the union budget and outside scheduled policy meetings (like a similar cut in January)—may be considered approval for the government’s bid to boost Asia’s third-largest economy, which has long trailed that of China.
In China itself, the economic growth target for this year has been officially reduced to “around 7%,” compared with 2014 GDP growth of 7.4%. While still high, such numbers are well below the double-digit growth rates that China recorded just five years ago. But in China too, reforms are afoot. The country’s authorities have been keen to stress that a slowdown in growth to more sustainable levels is inevitable as efforts continue to reduce the economy’s reliance on fixed-asset investments and to increase the contribution from consumption and trade to a more balanced growth model. We believe this is a welcome bid to