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After what had been a disastrous few months for investors in the period up to late December, markets have been on a tear. For a period of about six uninterrupted weeks, risky assets have witnessed a near historic rally. The S&P500 alone rallied by 15% between its nadir in late December and mid-February. This partly reflected a surprise improvement in the US data flow which ran counter to the extreme recession expectations that had prevailed in the market at the time. US PMI bounced back strongly in January and labor market data exceeded expectations. But importantly, the rally benefited from an additional impetus when the Fed signalled a pause in its hiking cycle and allowed for the possibility of altering the course of its balance sheet wind-down should it feel it necessary to do so. The Fed’s professed “patience” echoes its view in 2016 when instead of the planned four, it delivered only one rate hike. Just as then, concerns about external risks are rising, in particular with respect to Chinese growth. Indeed, China’s PMI has fallen into contractionary territory and is now at a similar level as 2016. While deflation is less of a risk now, worries over trade disputes have filled the space instead.
This represents less of a change in the Fed’s “reaction function” (as widely discussed among commentators), but instead a simple U-turn in its view given a previously worsening set of inputs. Perhaps the temporary government shutdown and some technical difficulties in implementing monetary policy under sharply reduced bank reserves may have played some role too.
But on the whole, the Fed is responding to a situation that sees growth revert to trend at the same time as policy rates approach the neutral range of 2.5-3.5%. In this environment and against a backdrop of heightened external risks, a patient and more cautious approach makes imminent sense. Indeed, the Fed could observe a sharp slowdown in the Chinese economy to which the authorities have responded with some stimulative measures, but not in an attempt to reinvigorate growth (given its concerns over excessive debt and capacity) but merely to stabilize it. At the same time, the Eurozone economy is decelerating sharply, while having few policy levers left to counter it and facing a potentially disruptive Brexit process at the same time.
The new environment has affected the monetary policy stance across the world. Partly in response to slower domestic growth, partly in response to the Fed’s retreat, central banks in both advanced and emerging economies have shed their hawkish rhetoric and embraced a more cautious outlook.
*The publication reflects asset performance up to January 31, 2019, and macro events and data releases up to February 15, 2019, unless indicated otherwise.
The information contained herein is obtained from sources believed by City of London Investment Management Company Limited to be accurate and reliable. No responsibility can be accepted under any circumstances for errors of fact or omission. Any forward looking statements or forecasts are based on assumptions and actual results may vary from any such statements or forecasts.
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