The US Federal Reserve’s decision not to take action on interest rates last week means the issue will no doubt be on the table again next month and maybe again in December. While the imminent hiking cycle may lead to some reshuffling of sector performance rankings, it need not jeopardise the overall equity market trend. Our base case is for the Fed to hike rates for the first time in eight years before the end of the year.
US, Euro equities held up well during last Fed hiking cycles
Fed keeps the lift-off question on the table
Two topics that have preoccupied markets in recent weeks are the slowdown in growth in China and the timing of the lift-off of the Fed’s monetary policy. The Fed kept interest rates unchanged last Thursday, citing growing uncertainty in the global economy, but left open the possibility of a rate hike later this year. Fed Chair Janet Yellen said a recent fall in U.S. stock prices and a rise in the value of the dollar already were tightening financial market conditions, which could slow U.S. economic growth even without Fed action.
The decision prolongs the uncertainty for at least another month. There are currently no signs of an acceleration in wage growth and inflation expectations remain in check, also helped by low oil prices. According to the Michigan survey, longer-term inflation expectations remain at the low end of the past five years.
Emerging markets remain epicentre of turbulence
The recent turmoil in financial markets was another deterrent to a rate hike. Ever since the surprise depreciation of China’s yuan in August, market volatility has spiked and markets have corrected substantially.
The centre of the problem is emerging markets (EM) in general and China in particular. These countries are confronted with rising debt levels, a slowdown in growth and increasing capital outflows. The weakness in commodity prices puts a lot of pressure on the commodity-producing countries across the globe.
A US rate hike would have no doubt exacerbated these issues, leading to further capital outflows and weaker currencies, tighter monetary policy in EM and further deterioration in the growth outlook. From this point, a vicious cycle may start. Next to China, Brazil is in bad shape, having its sovereign credit rating downgraded to junk. The country’s currency has already taken a beating this year, losing over 30% against the USD, and its budget projections have been revised sharply lower.
Equity markets held up well in earlier hiking cycles
For the Fed, the issue of whether or not to hike will be back on the table in October, and perhaps December as well. And while EM remains a bad place to be, the situation is different in developed markets (DM). Historically the Eurozone equity market has not done badly when the Fed started a rate hike. The graph shows that in the past three hiking cycles, markets moved either slightly lower (1994-1995) or substantially higher (1999-2000 and 2004-2006). The weaker readings for the first period can be explained by the surprise of the hike and the subsequent 200bp increase in the 10-year bond yield. At the same time, the USD weakened against the euro over the cycle, from 1.115 towards 1.269, which was not helpful either. One common feature for all three periods was the sharp rise in earnings per share; a second was the outperformance of non-US markets relative to US markets.
Every hiking cycle is different, however, and the one that looms ahead is special in that it will start with the first US rate hike in eight years, and in that it comes very late in the earnings cycle. Secondly, both the European Central Bank and the Bank of Japan are still in easing mode. Thirdly, at least the early phases of this cycle will be very gradual given the absence of inflation pressures. Finally, the imminent start of the cycle has been well-flagged and will come as a surprise only to those who think the Fed will not be able to hike any time soon.