A fortnightly look at global financial markets – 25 May 2016
The following is a detailed commentary and analysis from deVere Group’s International Investment Strategist, Tom Elliot regarding worries over US interest rates and how investors should respond.
Q2 asset allocation preferences (unhedged US dollar-based, updated at start of quarter): neutral equities vs. fixed income relative to benchmark. Within equities, favouring a low volatility/ high dividend strategy and a small overweight in Canada. Within fixed income, neutral. Longer term outlook is to be pro-risk assets.
US interest rate fears once again dominate the financial news. But how many times in recent years have we seen the same dance as we saw last week, only for the Fed to postpone taking action because the very fear of tighter monetary policy from the Fed has itself created tighter monetary conditions in the market (through a stronger dollar), and to US and global capital market instability?
The Fed’s dance with the market goes as follows: first, hawks in the Fed point to a slight upward move in inflation or jobs data as a reason to hike rates. The dollar rallies, bond and equity markets fall around the world as a ‘risk off’ trade becomes the dominant consensus. Second, we worry about China, where the renminbi is pegged to the dollar. Can China’s weakening economy withstand a stronger dollar? The last time China effected a meaningful devaluation of the renminbi (of 3%, last summer) it led to global market chaos. Simultaneously commodity prices fall on China growth fears, and an expected weakening demand (since most commodities are priced in the now-more-expensive dollar). Third, the Fed announces that a stronger dollar has reduced domestic inflation fears (that only it ever had), and due to instability on global financial markets and the negative effect of a strong dollar on China and on highly indebted emerging market countries and companies, it will delay a rate rise.
Investors should sit out this dance and carry on as before. The risk is that by being out of the market when the Fed announces a delay in rate hikes, we will miss out on the subsequent re-bound in risk assets.
A June interest rate hike from the Fed?
- Capital markets experienced a wave of fear last week after the Fed’s April meeting minutes were released on Wednesday, that suggested financial markets were too complacent over the outlook for future US interest rate hikes. This tone was echoed in separate statements by the heads of the Boston, Atlanta and New York regional Fed banks during the week. The interest rate futures market was pricing in a less than a 10% chance of a 25bp rate hike at the Fed’s June 14-15 meeting at the start of last week, but has risen to a 30% chance as of Friday. It is now pricing a 51% chance for the next rate hike to be by the end of July.
- The heads of the Feds pointed out that that inflation data has been picking up, and that Q2GDP data looks set to be an improvement on the disappointing +0.5% annualised growth rate seen in Q1. For example, in a convoluted statement by Dennis Lockhart of the Atlanta Fed, and reminiscent of the opaque utterings of former Fed chairman Greenspan, ‘the markets may be underestimating the degree of open-mindedness’ about the Fed’s option for a near-term increase.
- The odd thing is that while April CPI inflation was up over March’s number, at 1.1% y/y it remains well below the Fed’s 2% target. Core inflation (stripping out volatile items such as energy) was higher at 2.1% but that is down from March and -to my knowledge- is not the index tracked by the Fed. Meanwhile the risk of wage inflation emerging from a tightening labour market appears remote: April’s non-farm payroll came in at 160,000 new jobs created that month, well below the 200,000 expected number, and leading to a headline in the Financial Times of 6thMay ‘US rate rise chance recedes as jobs growth slows’.
- Is this a cunning plan, worthy of Baldrick from the BBC’s Blackadder comedy series? In which the Fed issues warnings of tighter monetary conditions in the expectations that the market will react in a manner likely to deliver that very tightening, without the Fed actually having to raise rates (principally through a stronger dollar)? Unlikely, even though that is what will probably happen.
- More likely it is the hawks in the Fed, eager to ‘normalise’ interest rates to 3-4% or so, clinging on to any data they can find to justify an essentially ideological rather than practical policy stance.
How should investors respond?
- Assuming investors are in a fully diversified, multi-asset portfolio, there seems little point in reacting to the current nervousness by imitating the market consensus and withdrawing exposure from risk assets (eg, growth-orientated stocks and stock markets, and high yield bonds) in favour of more defensive assets or cash. Your stock broker will be grateful for the commission, but will probably be unable to advise you when to correctly re-enter the market, and so you will risk missing out on the market’s recovery. Recent recovery rallies, such as in September of last year and the six weeks from mid-February of this year, have been short and powerful and have done much to make up for earlier losses.
- However, those investors who are looking for short term strategic play may want to use cash holdings to invest in those markets that will do well from a stronger dollar (eg, Japanese and euro zone stock markets), and/or from the deflationary risks of a premature Fed rate hike in June (long duration core government bonds).
- Best option, though, is to sit this dance out.