Two pieces of the US economic recovery puzzle have been missing for a long time.

The first is wage growth. Finally, the first signs of faster wage increases, though modest, have materialised. This is positive from a macroeconomic perspective and is a sign of health in the domestic economy. Could this trend indicate a rebalancing between capital and labour and a headwind for corporate profit margins? It remains to be seen.

The other piece relates to the US consumer. This piece of the puzzle, after several months of poor weather and higher-than-expected savings, has also fallen into place. The windfall from a lower oil price and the recent improvements in wage growth are starting to generate extra demand.

For these reasons, our macro research team recently upgraded its view on the US economy. In addition to the well-documented economic recovery, the first modest signs of wage pressure have emerged and will contribute to higher spending.

However, good news is also bad news. There are several reasons why the US Federal Reserve may soon choose to raise interest rates:

• The desire to inject some discipline into the world of credit

• The need to move the Federal Funds Rate to a high enough point where it could be cut if a recession were to emerge

• The expectation that, as unemployment approaches the NAIRU (non-accelerating inflation rate of unemployment), this will cause some wage inflation

This last point is increasingly important; if the next Employment Cost Index and Average Hourly Earnings data releases confirm the trend, the Fed will find it extremely difficult not to act. The one deterrent to any change in monetary policy would be financial chaos caused by the Greek situation, which is “a huge wild card”, as Bill Dudley from the New York Fed recently reminded us.

Global market upheaval

One aspect which we specifically focused on this month was market expectations. Due to the recent global market upheaval, investors have become very dovish, with markets not expecting the first 0.25 per cent Fed rate increase until the December 2015 — February 2016 period. We think that the market is too complacent, and that it will be forced to bring its rate rise expectations forward as the strength of the US economy becomes apparent.

The adjustment process is going to prove problematic for a few reasons. First, the market is barely pricing any rate increase for 2015 and would need to come in line. Second, secondary bond market liquidity conditions have been deteriorating for a while and are expected to be particularly poor during the summer months. Third, we have no experience of a Fed rate rise during a period of mediocre single-digit earnings growth. Fourth, the US equity risk premium has recently deteriorated somewhat, thanks to uninspiring earnings growth and higher bond yields.

While we expect some volatility at this very important inflection point in monetary policy, the long-term forecasts remains quite benign; we expect to face a modest set of rate increases, which will be very gradual and will probably never reach levels which would be considered ‘normal’. Long live financial repression.

In the land of quantitative easing, Japan and the Eurozone continue their progress.

In Japan, there is still a lack of momentum on domestic indicators such as wage growth and industrial production; however, the positive momentum in Japanese corporate earnings continues unabated across sectors, continually beating consensus. We regard Japan as a good investment opportunity due to an attractive equity risk premium and improved earnings. Japan is the only developed market to have delivered improvements in both return on equity and profitability, while maintaining an attractive market valuation.

The Eurozone has seen some recent improvements on consumer spending, corporate earnings and money growth. Also, the equity risk premium remains attractive. Unfortunately, the picture has been clouded by the thunder of the Greek gods. Here, we remain convinced that, perhaps after the painful experience of bank closures and capital controls, a solution will be found.

Challenges

The third country which has relaxed monetary policy is China. With serious challenges to its economic growth and corporate profitability, the People’s Bank of China has come to the rescue with various measures. However, the challenges are huge and the outcome uncertain. Meanwhile, the domestic equity market has started to deliver volatility which would be unthinkable in any of the major markets.

Having considered the US economy and the probable rate rise from the Fed, we decided to downgrade equities and high yield from preferred to neutral.

Within equities, our positive stance on Eurozone and Japanese equities remains firmly in place. Emerging Asia has been upgraded to preferred, while Emerging Latin America has been downgraded to not preferred.

On sectors, telcos have been downgraded to neutral, while we have moved financials to strongly preferred, with a special preference for US banks, given the benefits which could arise from a stronger domestic economy and a tightening of monetary policy.

In fixed income and currencies, the only change was an upgrade of Italian government bonds, as we believe that value in the European periphery has started to re-emerge.

The writer is Head of Multi Asset Group, Baring Asset Management, London.