Capital Brief: China, the Fed and the Neutral Rate

October 11th, 2018|

With the midterm elections right around the corner, many investors were thinking of a different sort of “October Surprise” than the one that hit the markets over these past two days. While downside volatility is never much fun, the CPA Investment Team wanted to highlight some of the main reasons for the recent market decline and explain why we are not overly concerned about the broad market action.

There were many factors that led to the speed and size of the two-day selloff, but three important catalysts were: 1) news from China that implied they would not defend the level of the Yuan versus the Dollar 2) the resulting increase in the Dollar and 3) concerns that a stronger Dollar would increase pressure on emerging markets as well as embolden the Fed to raise rates faster than the market currently expects, causing a premature end to the current economic expansion.

We think these concerns are overblown. The Fed has a dual mandate to maintain economic stability and to modulate inflation. They have a number of tools at their disposal to accomplish these things, and primarily use changes in short term rates to expand or constrict monetary policy. If policy is too loose, the economy and inflation can overheat; conversely if policy is too restrictive, the economy will slip into recession. Therefore, the Fed seeks to achieve the Neutral Rate – i.e. one that neither is too high or too low, or for those economic Goldilocks fans out there, the rate that is just right.

The neutral rate increases over time, as our economic capacity and growth rates continue to improve from the Great Recession. The CPA Investment Team thinks that rate reaches the mid-3% range later in 2019. Our research partners at Cornerstone Macro have done a great job at illustrating the relationship between the market rate, neutral rate and the effect on broad equity markets below. Very simply, as the market rate approaches the neutral rate, equity markets tend to pull back a bit, but resume shortly after presuming positive economic trends are intact. Additionally, the lagged effects of China’s 2018 fiscal stimulus ought to help counterbalance the Dollar’s rise and help provide support to the emerging economies and markets.

Cornerstone Macro

Economic fundamentals remain strong and earnings growth continues to support the case for equities. We expect volatility as the Fed and other central banks work towards removing excess liquidity from the monetary system, but our base case holds that they do so slowly, steadily and with the neutral rate in mind. Broad markets have come down to support levels and may bounce around a bit over the next few days or weeks as we move through earnings season, but we are confident that yesterday’s action is not the start of something more foreboding. As always, your Capital Planning Advisors Team is here for you – please call us if you have any questions or concerns.