Real rates set to rise, but at what pace?

03/12/2018

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Head of Global Asset Allocation Ashwin Alankar considers rising real interest rates to be a key theme for markets and the economy in 2019 as the Fed’s normalization program possibly reaches its final stretch.


What are the key themes likely to shape markets in 2019?

Investors need to keep their eyes on the trajectory of real interest rates. Real rates matter, as they represent the cost of money and affect everything from corporate capital allocation decisions to the prices of financial assets. We expect real rates to gradually rise over 2019, driven by greater confidence in the U.S. economy. Real rates have finally crested 1% and market-based inflation expectations currently sit at the Fed’s 2% target, resulting in the nominal yield on 10-year Treasuries of around 3.2%. As comfort with the U.S. economy strengthens, we expect real rates to gradually rise toward normalized real GDP levels, which we believe to lie between 1.5% to 2%, as they ride the “coattail” of the Federal Reserve’s (Fed) moderate hiking campaign. This implies real rates have another 40 to 65 basis points before the Fed’s normalization goal is complete and the cost of money is fair. This “soft landing” scenario would be favorable for risk assets. However, should real rates jump violently as a response to inflation, a second, offshoot theme comes into play for next year: an inflation-driven “hard landing.”


Where do you see the most important opportunities and risks within your asset class?

An upside surprise in inflation, I believe, is the biggest risk to markets and the economy as it may force the Fed to tighten more aggressively, risking real rates rising above normalized GDP and the “cost of money” becoming expensive. There is plenty of kindling to ignite inflation. Among them are higher tariffs, as they would raise input costs for industry. Fiscal policy is another potential source, as large-scale stimulus in the form of tax cuts at this stage of an economic expansion is unconventional. A tight labor market is another risk, as rising wages are a common source of inflation in service-based economies. Another, less talked-about source is the Fed hitting the pause button either as the result of being jawboned by President Trump or its history of being unable to orchestrate a soft landing. In recent years, the Fed has emphasized proactive over reactive decision-making as evidenced by them raising rates despite muted – if any – signs of inflation. This assertiveness has kept them ahead of the curve. Ironically, President Trump’s gripes about rising rates could result in worse damage if the Fed were to fall behind the curve and subsequently have to rapidly raise rates to quell inflation. Fortunately, options markets signal that inflation remains in check, giving the Fed the luxury of raising rates gradually. As a result, we consider global equities the most attractive opportunity for 2019.


How have your experiences in 2018 shifted your approach or outlook for 2019?

This past year proved to us that the normalization process, especially with regard to monetary policy, is well underway. Our fear is that many investors, lulled into complacency by nearly a decade of cheap money, are not prepared to navigate markets with normalized levels of volatility and a wider range of investment outcomes. A low cost of money has allowed many suspect business models to survive and dampened volatility. As real rates rise, only businesses that can deliver real returns in excess of now-higher real rates will prosper. Those unable to meet that threshold will likely cause pain for investors not used to doing their homework. In an environment with a widening spectrum of outcomes, active managers are likely to have an advantage in picking winners and avoiding losers. 2018 also illustrated the need for investors to discount the noise. There were many hot-button issues that moved markets due to what we like to call “fragility” in market sentiment, but in reality had little impact on the long-term prospects for the economy. This past year was not one for bulls or bears, but rather butterflies. This caused many investors to take their eye off what really matters, and that is normalizing real rates.



Which themes have the potential to redirect markets in 2019? Download our one-pager summary to find out




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