INSIGHTS

On July 22, 2016

Central Bank Easing On Tap

The surprise vote by the U.K. to ­exit the European Union (“Brexit”) has introduced significant uncertainty into the path of potential outcomes for both the real economy and in markets. The VIX (Volatility Index) spiked to 26.3 after the Brexit vote, despite ending the month at 15.6. Equities were mixed for the month. U.S. equities were up modestly 0.1%, while the MSCI EAFE Index fell -6.3% and the MSCI Emerging Markets Index was up 3.3%. The 10-year Treasury yield moved even more to 1.47% down 38 bps (basis points) from the prior month end.

Despite the debate over whether or not Brexit will actually take place, we see increasing pressure on global central banks to ease monetary policy conditions. We see the Federal Reserve (Fed), Bank of England (BOE), Bank of Japan (BOJ), and European Central Bank (ECB) all easing either by fewer rate hikes, as in the Fed, or more unconventional policies.

U.S. economic conditions have not changed materially since the Brexit vote. Consensus GDP growth expectations for 2017 moved down 14 bps, or closer to 2.0% for the year. However, we see the international business and political landscape as limiting the Fed’s ability to normalize policy, despite overall reasonable growth and labor conditions. Figure 1 below illustrates the number of expected rate hikes priced in by markets for 2016 through 2018. The number of expected hikes has dropped dramatically to fewer than one hike from over two the prior month.

On the other hand, economic conditions outside the U.S. have dimmed considerably since the Brexit vote. Consensus expectations for U.K.’s 2017 GDP growth fell to 54 bps or down 150 bps from the prior month. This adds more pressure for global central banks to provide quantitative easing.

The dollar rallied after the Brexit vote ending June at 96.14, up from 93.5 on the day prior to the vote. As the market pushes out rate hike expectations and presuming the flight to quality bid subsides, the pressure on the dollar should be mitigated some. The economic recovery remains fragile in our opinion; our expectations for 2016 U.S. GDP growth has downshifted to 2%, which is lower than the actual growth rate of 2.4% average for 2015 and 2014. Plus, we remain concerned about U.S. manufacturing, which has been in a profit recession for several quarters; manufacturers remain susceptible to a stronger dollar.

China concerns also remain and, in our view, internal re-balancing toward a consumer-driven economy away from an industrial export-driven economy likely puts the brakes on multi-year growth trends. We see the recent debt-driven growth recovery so far in 2016 as helping to stabilize China’s situation, but we expect further slowing in the years to come based on current factors.

Monetary policy has been on the front lines of supporting global economies as heavy sovereign debt burdens keep fiscal policy sidelined. International developments have taken center stage on influencing monetary policy in our view, and have created the need for more easing. Despite the shocker in the U.K. referendum on Euro-zone membership, we believe the dollar should remain relatively stable as monetary policy expectations even out globally rather than a decoupling Fed. In addition, negative interest rates overseas, stronger dollar, and China currency volatility all limit the Fed’s ability to normalize.

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Opinions in this piece are those of HIMCO and are not necessarily that of AAM.

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The forecasts, opinions and estimates expressed in this report constitute the HIMCO’s judgment as of June 30, 2016 and are subject to change without notice based on market, economic and other conditions. The assumptions underlying these forecasts concern future events over which we have no control. The assumptions may turn out to be materially different from actual experience. There is no guarantee that any forecasts made will come to pass. Sectors referenced should not be construed as a solicitation or recommendation or be used as the sole basis for any investment decision. All data contained in this material is from sources deemed to be reliable, but cannot be guaranteed as to accuracy or completeness. All investments are subject to risk, including possible loss of principal. Fixed income investments are subject to credit and interest rate risk. Investments in high yield and foreign securities involve risks beyond those inherent in higher-rated and solely domestic investments. These risks are magnified in emerging markets. Past performance is no guarantee of future results. It is not possible to invest directly in an index.

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