Real rates, growth and a flattening yield curve

Last week the US Federal Reserve continued its policy of monetary tightening, increasing its benchmark rate by 25 basis points in contrast to the cautious tone adopted by the European Central Bank and its president, Mario Draghi. As US interest rates rise to combat inflation, investors will be monitoring any signs of overshooting, which may restrict the American economy, fuel volatility and dampen demand for equities.

For the global economy, a recession in the US remains the biggest single risk. Today, the US is enjoying high levels of confidence among businesses and households and a sound outlook for growth, despite the late stage of its economic expansion.

Curve flattens as cycle matures

Yet the US yield curve is flattening. Today, the difference between two-year and ten-year Treasury bills is below 40 basis points (bps), the narrowest spread since 2007. Historically, whenever a flat US government yield curve for bonds has gone further into an inverse yield curve (in recent years in the early 2000's and then 2007), it has been followed by an American recession. An inverse yield curve (short-dated yields rising above long-dated yields) has been seen before every recession since 1945.

We are also experiencing a long-term decline in the economic growth potential of the US economy (from 4% in 2000 to about 1.7% now). In the past, real interest rates rising above US potential growth have been followed by recessions. For now, US financial conditions are still supportive, with real rates that can hardly be considered prohibitive for economic participants. They remain below this cycle's “danger zone”, which we estimate at between 1% and 2% (see chart). This indicates that we may have another 150 bps of real rate increase before rates start to impact the economic conditions enough to cause a substantial correction in the markets.

Threats to global expansion

If we take a more global approach, major economic indicators such as trade, the global Purchasing Managers' Index and industrial production all point to steady, broad-based, sustainable growth in manufacturing and services in the US, Asia and Europe. With the exception of Latin America, the volume of exports remains supportive for most countries – including the Eurozone and China. And in broad industrial terms, steady demand and a continuing supply of affordable capital are a sound basis for continuing corporate profits. Nevertheless, there are a few sources of instability that may undermine equity markets in addition to rising US rates. In Europe, market sentiment was recently tried by Italy's process of forming a new government. Yet even here, as we pointed out in recent articles, there is an institutional rather than a solvency crisis. Nor does the current Italian government have a popular mandate to provoke a wider crisis by leaving the Eurozone. Though it may well create more tension, notably with Italy's German neighbour, by raising government spending to stimulate some economic growth.

We remain, however, optimistic about the Eurozone's outlook, where we see no signs of a significant slowdown: the region is preparing to weather the end of quantitative easing this year and the ECB has lifted its inflation forecast to reflect rising oil prices.

Other signs of volatility which may affect global equity markets include vulnerabilities in emerging markets. While some are facing heightened political risk with important elections in the coming months (Mexico and Brasil), other economies are struggling on the economic front, such as Turkey and Argentina. We thus expect volatility to persist in emerging markets over the next quarters, but stronger fundamentals and a young cycle indicate that most of emerging economies are better able to withstand instability than in the past. For investors, emerging markets continue to represent an opportunity, but selectivity remains key in the current environment.