While the gaze of the investment world is currently firmly fixated on the US election, Eoin Murray, Head of Investment at Hermes Investment Management, believes the upcoming Federal Reserve rate decision holds far greater significance for markets.
The US election is dominating the landscape at the moment and it is very difficult for investors to look beyond this event.
While there have been numerous soundbites and argumentative rhetoric from both candidates, from a pure economic standpoint, both Hillary Clinton and Donald Trump have outlined plans that are likely to be both negative and positive for markets. For example, Trump seems to hold a more protectionist agenda, but he is likely to increase domestic spending. In any event, the final make-up of the US Congress is as important as the presidential vote itself.
I certainly would not advocate investors making drastic changes to a portfolio ahead of this election. While there is the possibility of an initial knee-jerk reaction from markets, particularly if underdog Trump emerges victorious, a result either way is unlikely to have a dramatic impact on the US economy over the longer term.
With the focus solely on the election right now, there is a danger investors are overlooking what I perceive as a more significant event on the horizon – December’s FOMC meeting. The market is forecasting a 70% chance of a Fed hike, but I remain deeply sceptical and expect rates to remain on hold. If the Fed is good to its word that monetary policy decisions will be data-led, rates should remain on hold as there is still plenty of uncertainty in the numbers.
The recent US inflation figures were once again softer than expected, while the Fed's twin mandate means there is also a need to take a closer look at unemployment. Many argue the US labour market is becoming tight, but the Fed’s own Labour Market Conditions Index remains weak and the federal income tax take has been flat year-on-year. This data suggests the US is not at full employment just yet.
Source: Federal Reserve Economic Data
If there is no move in December, there is an increased chance rates will remain hovered at these low levels throughout next year – due to the upcoming rotation of the FOMC voting membership, with some of the more hawkish members being replaced by more dovish individuals.
What does this all mean for markets? Should the Fed remain on hold it will again provide a boost for risk assets. But if the market is right, I do expect risk assets to take a hit going into year-end.
It is worth noting investor cash holdings are at the highest levels since the immediate aftermath of the September 11 terrorist attacks more than 15 years ago. This suggests many market participants remain wary. I believe investors are right to be nervous towards government bond markets, as valuations have become distorted. However, the situation for equity valuations is more complicated.
Current cyclically-adjusted P/E levels are at 26x for US equities, relative to a 30-year history of 25x. Today's valuations only get expensive in comparison to the 100-year average of 16x, but the economy has evolved considerably over this period so perhaps a 30-year average is more appropriate. However, while equity valuations appear reasonable, earnings will need to reverse the current trend of mediocrity and start coming through for this constructive view to remain valid.
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