Asset Allocator: September 2015- Judging Interest Rates

Following on from the Federal Reserve's decision not to raise interest rates earlier this month, David Stevenson's latest Asset Allocator post focuses on how interest rate rises have historically affected different asset classes and whether the conditions are right for rates to rise in 2015.

 The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only.

 Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment.

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ASSET ALLOCATOR: September 2015 

 

23/09/15- Judging Interest Rates 

 

Anyone looking for evidence that stock markets are inherently unpredictable beasts should take stock of events over the last few days.

For much of the summer investors have been worrying about a simple equation that suggests…. Increased Interest Rates = Bad News. As we’ll explore in a little detail below this fear was always largely irrational as evidence tells us that in the past small, incremental interest rate rises have actually been GOOD News for equity investors.

Not that investors seemed to care about this historical evidence. As a consequence last week the markets were on tender hooks about interest rate rises in the US.

The Fed then decided to NOT raise rates but investors reacted by dumping risky assets, worried that the Fed might actually know something everyone doesn’t – that we are one step away from a recession again. As we’ll discover shortly, there is some evidence from an unusual quarter that this worry might not be entirely misplaced.

Regardless, overnight in the topsy turvy world of equity markets Taper Tantrum had mysteriously turned into Rates Resignation.

Ever since this important non-decision, investors have steadily worried themselves into panic, helped along by continued evidence that China is in some trouble.

Given these swings in mood as well as reasoning, it’s no surprise that many investors are now frankly confused. Is a rates rise bad news or good news? Should rates rise to contain future inflation expectations or should we in fact be cutting rates as the Bank of England’s chief economist recently mooted?

As I have noted before in these articles my core suspicion is that we are in a growth scare and that soon most investor’s will learn to stop worrying too much about China and  recover their investment mojo. Who knows maybe an increase in interest rates in the US in October will have the perverse effect of rallying the equity bulls?

This outcome might not be quite as bizarre as it first sounds. The traditional logic is that a cycle of rising rates indicates that we are near the peak of an economic expansion, with a recession no more than a few years away. Rising interest rates also have an immediate impact on the risk free rate which is used within most equity valuation models.

But a closer look a past rates hike cycle doesn't actually back up this conclusion. Analysts at ETF firm Source have looked into the history books and they've discovered that in fact market returns tend to be positive and volatility low when the US Federal Reserve (Fed) starts to raise interest rates. The firm notes that the Fed has now kept rates at current historical lows since 2008 – indeed, taking into account the effects of Quantitative Easing and that each $150–200 billion of asset purchases is equivalent to a 25 basis points cut in Fed policy rates, the effective rate of interest in the US is currently -5%.

Looking at six previous rates hike cycles shows that the tightening phase lasted an average of 13.7 months and the average rate hike was 281 basis points (21 basis points per month). Source suspects that the forthcoming cycle may be slower and longer given the relatively larger headwinds, and is forecasting 25 basis points per quarter over multiple years depending on the rate of inflation.

And what of individual asset classes and regional markets? The table below shows that the best performers proved to be global equities generally, emerging market equities specifically and commodities.

Average annualised returns, in USD, during previous Fed tightening cycles

Global Equities

9.60%

Global Government Bonds

4.00%

Global Corporate Bonds

2.70%

Global High Yield

2.90%

Emerging Markets Equities

11.90%

Emerging Markets Government Bonds

4.80%

Commodities

18.00%

USD Index

2.20%

 

So, if interest rate rises are not such a bad idea for equity investor’s, what should we think about the prospects for a rates rise in October?

My own guesstimate is that the Fed will have taken note of the recent fall in stockmarket prices and might now feel emboldened to finally bite the bullet and go for a rates rise next month.

Of course the central bankers won’t solely be basing their analysis of what to do next based on what might happen to shares – perish the thought. They’ll also be guided by macroeconomic observations and future policy considerations.

On this score a recent note from analysts from Deutsche Bank beautifully summed up the compelling case for raising interest rates now. They suggested that:

  •   “The US labour market is at or very close to full employment, with good prospects for tightening significantly further, indeed excessively, even if the Fed starts raising rates now.
  •  While some emerging market economies may be vulnerable, global growth prospects, in our view, have not weakened enough to significantly affect US economic prospects.
  •  US inflation is being held down only temporarily by the strong dollar and the downshift in commodity prices, and unit labour cost inflation is already at levels consistent with the Fed’s longer-term objective
  •  This is an economic picture that says it is no longer appropriate for the Fed to be so far away from neutral in both its policy rate settings and its balance sheet policy.
  • The presence of long and variable lags in the effects of changes in monetary policy means the Fed increasingly runs the risk of falling behind the curve on inflation the longer it delays lift-off.
  • Having to tighten more aggressively down the road to keep inflation at bay could be far more disruptive to the US and global economies than beginning the process sooner (now) and reducing the chances of having to shift to a more aggressive stance later.
  • While the costs of putting off lift-off will not be apparent immediately, they will likely mount over time, especially if the Fed tries to stick with its signalled intention to normalize policy at a much more gradual pace than it has employed in the past. If the Fed does choose to delay this week, the delay should be a brief one with some indication that the October meeting is very much in play”.

I find this argument hugely compelling, not least the common sense of getting some difficult policy moves out of the way now. On this logic a rate rise in October looks a better than 50/50 bet. 

But there is one last fly in the ointment – evidence that the US economy might be closer to a slow down than we all believe. A note this week from analysts at Cross Border Capital (regularly highlighted on these pages for their research into global liquidity flows) looks at recent downward trends in both manufacturers confidence (measured by the US ISM index) and US capital markets liquidity. Using the chart below Cross Border’s analysts observe that “the latest dip in the US ISM index is not accidental since it follows the similar drop in US liquidity. Looking ahead, the odds of economic slowdown have increased. A rule-of-thumb suggests that an index reading below 52 signals US manufacturing recession. Although we are testing these levels, weaker US liquidity over coming months looks inevitable and this could easily throw the economy into mild recession in 2016. Could it already be too late for policy-makers to re-think their next move?”

If Cross Border are right maybe those arguing for a rates CUT (to what?) might get the better of the argument. My own sense is that sooner or later in the next two years we’ll be on the receiving end of QE4. Quite whether that will be treated as good or bad news by stock market investors is quite another thing!

 

 

 

 

 

 

 

 

 

 

 

 

 

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The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only. Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment. Links to external websites are not operated by or affiliated with Societe Generale. While we aim to point you to useful external websites, we cannot be responsible for their content or accuracy. Societe Generale takes  responsibility for the views expressed on any external websites or any liability arising from investment decisions you may make. You should seek professional advice if any of the content of this page is unclear.

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