Lombard Odier’s Asia CIO is keeping a watchful eye on the next Federal Open Markets Committee (FOMC) meeting as it could create two distinct market scenarios for emerging markets and fixed income investors.
The first, more predictable, scenario is one where the US Federal Reserve (Fed) hikes rates by 25 basis points to the 1.50-1.75% range during the 20-21 March meeting, potentially confirming three hikes by the end of the year.
‘If this scenario of a tolerance towards higher inflation materialises,’ Jean-Louis Nakamura said in a commentary, ‘nominal rates will edge only slightly higher, USD will resume with its previous depreciation path and equities will perform strongly, with emerging markets and currencies outperforming significantly.’
A weaker US dollar is good for emerging economies as it reduces their US dollar-denominated debt-servicing burden and supports better trade dynamics, especially for commodity importers. That, in turn, boosts the outperformance of emerging market assets.
However, Nakamura also laid out the possibility of a second scenario, where the FOMC ‘falters’ in terms of policy stance or communication by overreacting to short-term inflation-related newsflow.
Several market participants have pointed to uncertainty around US inflation as the main reason for the sell-off in global equity markets in early February.
The Fed studies the increase in personal consumption expenditures (PCE) price indexes produced by the Department of Commerce as an inflation measure among others, largely because it covers a wide range of household spending.
PCE, excluding food and energy items, came in at 1.5% in January, shy of the Fed's 2% inflation target. However, rising inflation has been sending jitters through bond markets and prompting investors to question central bank guidance.
An overly aggressive or hawkish stance by the Fed at this point could descend into an equity bear market, the CIO said. US equities are currently in the second-longest bull market in history, crossing nine years on 9 March.
However, higher-than-expected interest rates could tighten real financial conditions and squeeze the profitability of US companies, affecting investment and hiring decisions.
‘If that translates by a negative shock on stock prices that-through wealth effects-would depress private consumption, then the risk of a sooner than initially thought recession might emerge rapidly,’ he said.
This correction in equities could soon turn into a bear market, spilling into other assets, he added, where only long-term interest rates will offer protection after the volatility clears.
‘In the meantime, keeping our barbell positions between a still significant exposure to emerging assets and an increased one to long duration bonds remains – in our view – the best way to face those two opposing fronts,’ said Nakamura.