As expected, the US Federal Reserve (Fed) lifted its benchmark target rate by a quarter point to a range of 0.5% and 0.75%, and raised its 2017 rate hike projections to 3, from 2 in September, on the back of strong economic data. The hike widens the already expanding gap between the US and the rest of the world, opening up a new set of opportunities that active managers can explore.

Please see below insights from the Legg Mason and its Affiliate managers:

Western Asset – John Bellows, portfolio manager / research analyst: “The more interesting parts of today’s meeting came in the FOMC’s forward-looking assessment. The FOMC did not materially change its growth forecast, even though the market appears to have reassessed the outlook significantly since the election. The FOMC likely decided it was premature to make any meaningful changes to its forecasts for 2017 or beyond. For a group of careful, empirically oriented economists, there is too much uncertainty on the size, scope and specifics of the new administration’s fiscal policies, not to mention what those policies may mean for growth. There are real concerns about tighter trade policy affecting demand and risk sentiment. Finally, the FOMC is well aware of just how hard it is to generate a pickup in growth. The struggle of countries around the world to find a successful policy mix that leads to faster growth highlights this point.”

Brandywine Global – Jack McIntyre, portfolio manager: “In terms of how the decision will impact the U.S. economy, we think it will depend on how the dollar reacts to the Fed. At this point, the third potential rate hike is now driving the greenback higher against all currencies. This has been the trend after Trump’s victory and it is tightening for the Fed well above today’s 25 basis points increase in the fed funds rate. A strong dollar may not in the best interests of the U.S. economy but bond investors might like it as the dollar will put downward pressure on economic growth and inflation.”

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What was the market initial reaction? Equities fell as investors started pricing in the higher financing costs, while government bonds sold off, as bond prices move inversely to interest rates. Two-year US Treasuries, especially sensitive to Fed moves, spiked as much as 8 basis points to 1.25%, the highest since 2009. The US dollar soared to its highest level since 2003, something which could hurt countries with substantial amounts of US dollar-denominated debt, such as Brazil and Russia: the real fell c. 1% against the greenback, while the ruble dropped 2.2%. The Russian currency was also hit by a drop in oil prices: a stronger US dollar usually dents demand for dollar-denominated commodities, as it makes them more expensive. Oil plunged 4% to US$50 per barrel. Gold, often considered an inflation hedge, shed 1.2% as higher rates aim to rein inflation. The US 10-year breakeven rate, or the difference between nominal and inflation-adjusted real rates, edged lower. And so did the yen, down 1.6% against the greenback, as US securities become more attractive relative to Japan’s government debt, which mostly offers negative yields. The euro was down almost 1%, for the same reason. The cost to protect US corporate debt against default also rose, given the higher interest rates. Initial reactions may change as, while the Fed’s rate hike projections for 2017 were lifted, those for 2018 remained unchanged at 3.

Why does this hike matter? A US rate hike affects the entire world – through US Treasury (UST) yields, which as the world’s traditional “risk free” benchmark represent a floor for other US dollar-denominated debt yields – and through the US dollar, whose value is enhanced when higher rates attract capital from the rest of the world. Potential impact of the Fed’s move include: revaluation of fixed income debt based on new US Treasury yields; European, Chinese and Japanese exports may become more competitive as currencies weaken; downward pressure on commodity prices; pressure on non-US debt denominated in US dollars, and higher corporate financing costs. These are sheer changes which, combined with the present negative rates in Europe and Japan, may create opportunity for active managers.

Is the Fed now more aligned with markets? Yes: for years, the Fed has been overestimating its growth, unemployment and inflation projections, amid slow domestic growth and international headwinds. In 2016, the Fed has cut its own projections, while the market has increased its own, especially after Donald Trump’s US election victory. As seen in the chart, the two are now aligned.

Finally catching up: Fed and market rate expectations

 

The Fed VS. The World

The Fed has been scaling a wall of global challenges in its quest to return to more normal monetary policy. Previous Fed chairman Ben Bernanke’s hint in 2013 that the central bank planned to taper its stimulus sent yields soaring. Since then, repeated European crises, persistent low inflation, a shock Chinese devaluation, geopolitical tensions, the collapse of oil prices and last, Brexit, all refrained the Fed from raising rates more than once (in December last year). Now, more than 3 years after Bernanke’s first warning that rates should be more in tune with the real state of the economy, the Fed seems to be finally getting its way.

Another hike bites the gap


Source: Bloomberg as of December 9, 2016

What are the effects of rising rates on equities?

The rate hike seems to have confirmed what US equity markets have been signalling for several weeks: rising expectations for better economic growth in the months ahead.

  • Better growth should support US equity prices in general, but it is important to remember that US equity valuations, as reflected in popular market indexes such as the S&P 500, are currently above historical averages. That should temper expectations for future index gains and may even contribute to higher volatility as the market adjusts to a new economic landscape. However, it doesn’t preclude stronger performance in some sectors, industries and individual companies where valuations and/or growth prospects are better. For more, watch Seeing Growth Where Others Don’t.
  • While the recent focus has been on improved US growth prospects, the trend is actually global and that could mean better prospects for select areas in emerging markets, which have struggled over the past couple of years.
  • Additionally, if market leadership shifts from being driven by low interest rates toward fundamentals that reflect business strength, such as return on invested capital and balance sheet quality, then value stocks may continue to close the long-term performance gap with growth stocks that developed in recent years. For more, read The Undiscovered Connection.
  • With a rising rate environment, the importance of active management rises too. Active management, unlike a passive approach, provides the ability to be selective about with stocks to own and the flexibility to be responsive to market shifts that will accompany rising rates.

Dividend stocks can still play an important role in your portfolio – a rising rate environment should not be viewed as a reason to shun income-generating equities.

  • Even though bond yields have increased, many US stocks still sport competitive yields. As of December 2, 2016 the S&P 500 Dividend Aristocrats yield was 2.54% compared with 2.38% for 10-year US Treasury note. If rates stabilise and normalisation occurs gradually, then equity income remains an attractive opportunity.
  • And even if the Fed continues to raise rates, many dividend-paying equities may still do quite well. In fact, over the past 45 years many companies exhibiting dividend growth have outperformed those with static or decreasing dividends during periods of rate tightening. For more, see Shrugging off Rising Rates.

What are the effects of rising rates on fixed income?

  • Investors usually associate rising interest rates with bond losses – but that is not necessarily true: what is true is that the price component of bond returns falls as interest rate rise, this is how bond prices are calculated. But the large majority of bonds, unlike stocks, pay a coupon which can more than offset any price loss. This is especially the case in asset classes which pay higher coupons: US High Yield, for instance, pays an average coupon of 6.5% and its investment grade equivalent, of 4.0%. This more than the average US Treasury coupon of 2%.
  • Traditional, long-maturity, developed market sovereign bonds may be more vulnerable to rising rates because of their longer duration and lower coupons but, again, this may only be partially true: if investors perceive that higher interest rates will curb inflation in the future, long-maturity bonds may do well (or at least better than short maturity debt) as investors demand a lower yield to compensate for inflation risk.
  • The fixed income market has also substantially grown from traditional asset classes, offering the potential to generate positive returns even if government yields rise. The High Yield market, for instance, has more than doubled from US$638 bn to US$1.3 trillion over the past decade. The size of the local emerging market sovereign debt universe has also soared, to $1.6 trillion, from $1.0 trillion in 2008. For more, read: After the Clash: Tequila (EM) or Beer (US?).
  • Fixed Income asset management has also become more active, with new unconstrained strategies that invest in off-traditional benchmark assets, or that use derivatives to even have negative duration positions, which allow a strategy to profit from rising yields. Flexible and unconstrained managers may view the changing shape and slope of the curve as an opportunity, rather than a threat.
  • Some fixed income securities, such as bank loans or some structured products, carry a floating rate, which would rise as rates increase, delivering higher gains. Structured securities are backed by assets, such as mortgages, credit cards or car loans, whose value is traditionally linked to the fundamentals of the corresponding market. In this case, a strong US economy could underpin these securities.
  • Inflation-linked bonds could also hedge against rising inflation, as they adjust their payments to the inflation rate. They tend to become more popular as economic activity gathers pace.
  • An unconstrained, flexible approach may be an attractive option to navigate through an environment of rising rates and still-wobbly global economic growth. It can also be a tool to avoid, or profit from, ongoing risk. For more, read Global Bond Investing in a Low Rate World.

Is the US economy strong enough to bear a rising rate cycle?

Interest rates normally reflect the state of an economy. However, since the global financial crisis, interest rates around the world have been abnormally low (or even negative, in the case of Europe and Japan) as central banks have gone to great lengths to kick-start global growth. Now, as economies start to pick up, central banks want to normalise their policies by hiking rates to a level that better reflects real economic growth. But, is the US economy ready for a rising rate cycle? Is the recent risk rally and government bond sell-off justified by real economic prospects?

Media contacts

Shed Media

Simrita Virk
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E: svirk@shedmedia.com.au

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