Overall, 2017 was a good year for investors across asset classes. However, in 2018 we will likely see increasing divergence in returns among assets, particularly as the pace of interest rate hikes accelerates.
The Federal Reserve has signaled that markets should anticipate at least three interest rate increases in 2018, and we see some risk for a fourth. The Fed appears to believe that the case for raising rates is strong and the economy is robust enough to absorb increases. Where previously the Fed has combed economic data in search of justification for raising rates, going forward it will likely tighten monetary policy unless economic shocks demand it reevaluates its position. In short, the economic burden of proof appears to have shifted.
The primary driver of rising rates in 2018 will be the country’s healthy economic fundamentals. GDP growth accelerated to three percent quarter-on-quarter through Q3 2017. This is lower than the growth experienced in 2014 and 2015, but higher than the average growth of 2.1 percent year-on-year since the financial crisis. Looking ahead, the economy is likely to benefit from federal fiscal stimulus in the short- to medium-term. This may help sustain or modestly accelerate GDP growth in 2018.
Faster growth would be positive for equities, which tend to rise in line with rising corporate earnings. However, stock markets are currently trading near historically high valuations. Expensive equities may make fixed-income assets look relatively attractive.
In addition, quickening economic growth would likely pressure already-stretched labor markets. Unemployment is currently close to historical lows and, while the labor force participation rate remains muted, wages are beginning to rise as the labor supply tightens. Any further decline in the unemployment rate—potentially driven by fiscal policy—may pressure wages and spark broad-based inflationary pressure.
As a consequence of rising growth and potential price pressure, we expect a steady rise in interest rates in 2018.
Beyond the solid economic backdrop, there are other potential drivers that will support further hikes. First, the Fed may have some concerns about asset price bubbles in certain sectors and markets. Although the Fed has not explicitly expressed bubble worries, historically high asset values may prompt Fed action.
The Fed may also need to “reload its gun” ahead of an eventual future downturn. A worst-case scenario would see the economy sliding into recession amidst the current historically-low interest-rate environment. In such a scenario, the Fed would have virtually no policy tools at their disposal. More aggressive action in 2018 may help the Fed better respond to future economic slowdowns.
Given the country’s sound economic outlook and the Fed’s possible need to raise rates, we are therefore almost certain to see further rates hikes in 2018.
This environment—characterized by heightened inflation risk and steadily rising rates—represents a poor environment for traditional fixed income, with fixed-coupon fixed income risking a significant erosion of principal.
Floating-rate assets can help investors build a more-resilient fixed-income portfolio in 2018—they pay higher interest when rates increase and are better positioned to retain their value in a rising-rate environment. Floating-rate assets may therefore offer enhanced income returns with potential capital preservation.