Our Economy Is Truly Global—as Those Watching the Federal Reserve Learn

Global events—including the United Kingdom’s vote to exit the European Union—are playing a greater role in driving all markets and economic policies than in the past. As a result,
U.S.-based views of interest rate normalization require revision. We’re focusing increasingly on global signals, as the Federal Reserve has done.

The process of raising rates has been painfully slow. In our opinion, central banks—particularly the Fed—could/should be reversing the massive monetary stimulus unleashed after the 2008 financial crisis. Since then, the Fed has raised its interest-rate target once, by a mere quarter-percent, and bond market expectations of further rate hikes have been mostly subdued. In fact, on July 27, the Federal Open Market Committee decided to keep its overnight interest rate target in the 0.25 percent to 0.5 percent range. Meanwhile, interest rates in other leading
developed economies have declined and even gone negative.

Besides higher interest rates, normalization potentially represented several changes, including less central bank control of economies and markets, more market risk, and greater divergence in investment returns. Normalization also reflected a view of the world that was relatively U.S.-focused, where the largest economy and its central bank would help lift the global economy as economic growth in this country strengthened.

Instead, normalization has been delayed. Why? Primarily for global reasons, starting with China, the world’s second-largest economy and, until 2015, one of the fastest-growing. Growth problems in China have rippled through the global markets over the past two years, influencing emerging-market growth, stock prices, relative currency values and bond yields. The magnitude of China’s growth has profound effects on global commodities, energy and industrial goods prices. We have seen the ongoing results of the slowdown in Chinese growth since 2010. Currently, investors seem skeptical that the tools at the government’s disposal to invigorate China’s economy and stabilize the stock market can be effective.

Clearly, the Fed is swimming upstream against global interest rates. The Fed is in a very difficult position—after its rate increase last December, stock and high-yield corporate bond(1) markets sold off globally in January, leading other central banks to add more monetary stimulus. The Fed fears this could happen again.

In our expanding economic and financial world, global macro factors are increasingly driving Fed decisions and capital-market behavior. We’re increasingly looking for signals and opportunities outside the U.S., a key part of a process that we believe is essential to diversification and other portfolio risk-management strategies. A well-diversified portfolio is important in this effort because the diversification allows you to potentially maximize return for the risk you take, or to reduce risk for a given level of returns.

Turning to American Century’s asset allocation portfolios, we remain modestly overweight stocks. While stock valuations on the whole are not compelling, we think there’s a solid argument for favoring stocks over bonds in a balanced portfolio. This is true when you take into account the historically low level of interest rates on bonds and cash. Of course, this could change when the Federal Reserve does, in fact, rai-se its short-term rate target.

In addition, just under the sur- face of the market, there have actually been significant rotations and rolling corrections at the industry and sector levels going back at least to ‘15.

So while the market as a whole may be considered overvalued by some measures, we consider a number of sectors and industries within the market attractive. This ability to differentiate among individual stocks, industries, and sectors is actually one of the hallmarks of active management and is a central argument for active over passive investment approaches.

1. High-yield corporate bonds are higher-risk, high-yielding taxable bonds consisting of debt instruments from corporations rated below BBB- by Standard & Poor’s. Diversification does not assure a profit, nor does it protect against loss of principal.Generally, as interest rates rise, existing bond values will decline. The opposite is true when interest rates decline.

The opinions expressed are those of Victor Zhang and are no guarantee of the future performance of any American Century Investments portfolio. For educational use only.
This information is not intended to serve as investment advice.