Strong US economic data in recent weeks have caused analysts and economists to boost their expectations for US corporate earnings and the economy at large. The data have also led the Fed to reaffirm its commitment to removing policy accommodation at a gradual pace. On its face, it certainly seems as though the Fed is justified in continuing its present course. The unemployment rate has dropped below what many economists believe to be the Non-Accelerating Inflation Rate of Unemployment, or the NAIRU. At the same time, inflation is now at or above the Fed’s target of 2% as measured by a variety of different metrics. At this stage, then, it seems that better wage growth is the last remaining item on the Fed’s “wish list.” But while wage growth is certainly lower than we’d expect given a 4% unemployment rate, wages too are growing well above the Fed’s 2% inflation target. So what’s to keep the Fed from continuing its present course or even accelerating its policy normalization? Why is there any debate at all over the issue?
Aside from the risk of asset bubbles (which we believe significant and directly attributable to Fed monetary policy), the most threatening factor that could influence the Fed’s calculus is the action in the emerging markets (EM). A combination of trade-war threats, Fed interest-rate hikes, and softer EM economic growth has caused significant market volatility outside the US. EM currencies, stocks and bonds have plummeted in recent months, and this volatility could have very real implications for the rest of the world. Perhaps the most immediate threat is that EM entities have issued a massive amount of dollar-denominated debt in recent years. These issuers could have a much more difficult time servicing and refinancing that debt if capital continues to flee the EMs. And as we all have learned from the Financial Crisis, problems in one sector of the debt markets can easily spill over into sectors – a process known as contagion.
In the charts below, we show that in just a few months this year, an 8% decrease in the MSCI EM Currency Index has corresponded to 20% sell-offs in both EM equities and EM bonds.
We live in an increasing interconnected world. As such, the extent to which the US economy can “decouple” from the rest of the world is much more limited than it once was. You may hear the opposite from the pundits on TV, but the reality is that the currency and capital markets are forces that work to smooth growth rates across the world. We think there is a good chance that economists and the Fed will start to heed their warnings in the coming months.