Quick View: The Fed preaches patience

The Fed has a thankless job these days. During any shift in the cycle where the future path of the economy is uncertain, it must carefully balance both sides of its dual mandate. Complicating this decision-making framework by an order of magnitude is a potential reordering of the global system of trade – a development that could impact both inflation and the labor market.

Fortunately, at least according to Fed Chairman Jerome Powell, the U.S. central bank has the luxury of exercising patience to wait and see how the rapidly evolving policy backdrop further develops. And given the fluidity of policy pronouncements, delays, and not-so-veiled threats, the Fed has little choice but to lean into patience by keeping rates steady until the cloud of uncertainly hanging over the U.S. economy – and global markets – begins to dissipate.

Tensions abound

For much of the past two years, the market operated under the assumption that the U.S. was experiencing a late – albeit continuously extended – cycle economy. Bias, however, had been tilted toward slowing as the lagging effects of restrictive monetary policy were expected to eventually weigh on consumption and investment. That has not transpired. The labor market has remained healthy, and despite generationally high policy rates, progress toward the Fed’s preferred 2.0% inflation target has stalled.

The Fed is data driven, but that statement must be qualified by specifying that it’s hard data driven. Those hard metrics have held up surprisingly well, and despite weakening sentiment surveys and other soft data pointing to the contrary, the central bank had little impetus to pre-emptively cut rates while job growth and employment stayed at respectable levels. Still, hard data have a tendency to follow soft data, so weakness in surveys could not be entirely dismissed.

Injecting tariffs into the equation only adds to the tension the Fed is sensing. As Powell said, tariffs could be both inflationary – even if in the form of a likely implausible one-time step up in prices – and also weigh on growth, thus pushing up unemployment. Should both these dynamics emerge concurrently, the Fed would find itself in the especially thankless position of navigating a stagflationary environment.

What lies ahead

Markets rallied in advance of President Trump’s anticipated victory in last November’s election as investors welcomed the possibility of a pro-business agenda. Trade has since taken center stage and, as has been widely reported, the market grossly underestimated the size and scope of the proposed tariffs. While the ultimate level of tariffs – and their impact on the existing trend of deglobalization – is yet to be determined, their entry into the conversation marks a considerable shift in the prevailing global economic framework – and one that is largely considered a headwind to broad-based growth.

The Fed must also consider the tension between tariffs and the potentially pro-growth aspects of the Trump agenda, namely deregulation and fiscal policy. With those still on the horizon, Chairman Powell was able to maintain a modicum of sincerity when reiterating that it’s too early know for sure how the Trump agenda, in aggregate, might influence how the Fed approaches future policy.

The investment horizon

Near-term uncertainty is never embraced by markets. The recent fierce selloffs in riskier assets and (almost) equally impressive rallies signify that the policy and economic backdrops are still in flux. Investors can take solace – as does Mr. Powell – in the U.S. economy appearing on sound footing. Still, such periods of uncertainty, especially when the underlying driver is something of the magnitude of the global trade framework, are not times to take on excessive risk.

Tariffs entering the equation means that any thought the Fed had of prioritizing growth over inflation has ended. This would be especially true if a putative one-time step up in inflation resulted in the feared unanchored expectations – perhaps the greatest fear of a central banker. Within this context, now is not the time to extend U.S. duration.

With the U.S. being the nexus of the current uncertainty, other regions are rightly gaining attention as potentially attractive investment destinations. Countries facing a slowing economy are likely to continue cutting rates, potentially to below-neutral levels into an accommodative stance, hence boosting to their sovereign bond prices. And as with the U.S., most major markets have seen bond yields reset to levels closer to historical averages, meaning they could offer a level of carry not seen in over a decade.

Within credit, the combination of a late-cycle economy and tariff uncertainty causes us to prefer high-quality issuance: companies with conservative balance sheets and resilient coverage ratios. Such companies can be found across advanced economies. Consequently, credit investors can gain exposure to this segment without myopically focusing on the giant U.S. market. And this issuance can often present more attractive risk-adjusted opportunities relative to U.S. peers.

That said, the recent selloff in risk assets has seen U.S. credit underperform some of its developed market peers, resulting in some attractive relative value in pockets of the U.S. market. This tactical positioning, in our view, would complement the approach of applying a global lens to uncover attractive international opportunities.