The Federal Reserve hiking interest rates by the middle of next week now seems all but an inevitability.
This had been expected for several months, but the positive jobs report seems to have removed almost any doubt.
With year-on-year CPI headline inflation running at 2.5 percent in January, well above the Fed’s 2 percent target, a buoyant stock market, and GDP growth running at a steady (if unspectacular) 2 percent per annum, it is unsurprising that many economists and analysts are expecting the Fed to raise interest rates next week.
It will be perhaps three years before they are back to normalized levels, but they will get there and when they do, the U.S. and global economic landscapes will look very different.
Against this backdrop, investors need to do three things now.
First, begin to prepare for inflation. Many fear that higher wages will lead to demand-led inflation. However, January’s modest year-on-year wage growth of just 2.5 percent (which was down from 2.8 percent in December) suggests that there is still slack in the labor force. The economy might be able to continue to add jobs without running into a serious inflation problem - but we can be almost sure inflation is on its way within the next year or so.
You should start preparing for this now by keeping some powder dry because as the cost of goods and services rises, your dollar-buying power reduces.
Second, prepare for a fall in the greenback. Markets are pricing in three rate hikes this year.
I suspect they are wrong, and we will see just two, which will support stock market sentiment and lead to a fall in the dollar over the coming months.
The reaction from the bond market will depend on the progress of inflation, if weak wage growth persists there should be no reason for Treasury investors to take fright.
Third, ensure your portfolio is truly diversified. This is one of the cornerstones of successful investing, yet it is surprising how many investors fail to really achieve this.
Having a properly diversified portfolio across asset classes, sectors and regions means you are best-placed to mitigate risks and best-placed to take advantage of key opportunities.
Stay well-diversified and don’t try to be clever with regional or sector bets - correlation between regions and sectors has weakened since Trump came to power, and trying to guess which will outperform is difficult since much will depend on which way the dollar goes, and on which policies he can push through Congress.
One exception is the U.S., where a small cap bias might pay off. Large cap stocks will get less benefit from a stronger U.S. economy this year, because of their exposure to export markets. But small, and to an extent mid-cap stocks are well placed to benefit from an uptick in domestic growth.
Longer-term economic outlook
Slowly, and with much struggle with Republican Congressmen, the White House is likely to see its policies of business deregulation, an increase in spending on military and infrastructure, and lower taxes all enacted into law.
These will stimulate demand, leading to more rapid GDP growth (perhaps to an annualized rate of 3 percent by end of this year) and to higher inflation. Other policies, such as a proposed border tax on imports and/or import duties on selected trading partners, will directly raise the prices of imports and inflation.
Therefore it is reasonable to assume that the Fed will raise rates substantially once these policies start to deliver accelerating inflation, perhaps peaking at between 3 percent and 4 percent in the cycle – reflecting the Fed’s own view that weak demographics and increased savings amongst the late baby boomers will curb the need for much higher interest rates.
This is when, probably, the Wall Street party will end and the Trump reflation policy hit a brick wall. To avoid this happening, Trump will need to engage in more wide-ranging supply side measures than he is currently proposing. These should include improving the education and health of the workforce, and labor participation rates amongst women and minorities.
Nigel Green is founder and CEO of deVere Group. One of the world’s largest independent financial advisory organizations, de Vere does business in 100 countries and has more than $12 billion under advisement.
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