This is for investment professionals only and should not be relied upon by private investors

DECEMBER 2015

When US rates rise... For some time the dominant concern affecting US and global financial markets has been the outlook for US interest rates. In this perspective we look at current market expectations and examine whether investor concerns about the possible impact of rate rises are justified.

AT A GLANCE  Investors have been concerned for some time about the impact of a rise in US policy interest rates.  After many false dawns, a number of factors suggest this time is for real and the Fed will finally hike in December.  Rate rises are only being considered because the US economy is judged to be in a sustained recovery.  Crucially, very low inflation and the risk of policy error should ensure a very gradualist approach to rate rises.  The ‘savings glut’ and weak investment demand arguments still provide a rationale for structurally low interest rates.  Credit spreads are now much wider than they were at the beginning of previous rate hiking cycles, providing an extra cushion for investors against volatility.  While volatility typically picks up in the near term, in each of the last four rate tightening cycles, US equities were higher one year later.  With the uncertainty reduction that it also promises, the first rate rise from historic lows appears quite unlikely to derail the bull market in US stocks.

We make the case that rather than ‘lifting-off’, interest rates are likely to ‘crawl’ higher to a relative low peak level, limiting potential downside risks for fixed income markets. At the same time, removal of a major source of uncertainty could actually support at least a near-term continuation of the US equity bull market. RATE EXPECTATIONS - WHY THIS TIME IS FOR REAL Investment commentators have been earnestly debating the likely timing of the first US policy rate hike from virtually zero for several years now. However, each time an increase has appeared imminent, expectations have been dashed owing to either weak data or events, such as the recent China-related market volatility. A number of factors suggest that this time could be different and that the US Federal Reserve will finally increase the Federal Funds Target Rate (FFTR), probably in its December 2015 meeting or very soon thereafter. In particular, the factors supporting this view are: Robust employment data - the US unemployment rate dropped to 5.0% in November - the lowest since early 2008 - and is now towards the low end of most estimates of the ‘non-inflation accelerating’ level of unemployment. Incipient wage growth - a hallmark of the post-crisis economic recovery has been very low inflation and minimal wage growth, but recently wages have picked up. After a strong reading of 2.5% y/y in October 2015, average hourly earnings rose a further 0.2% during the month of November, which translated into a 2.3% y/y increase. Fedspeak – recent comments from Federal Reserve voting members and the Fed Chair Janet Yellen particularly have pointed to a rate hike being highly imminent, with the minutes of the last October 2015 Fed meeting showing that ‘most participants’ felt rate rise conditions ‘could well be met by the time of the next meeting’. Market expectations - history shows that the Federal Reserve seeks to avoid surprising markets, typically only raising rates when there is at least a 70% market implied probability of this. Following the strong October employment report, market expectations for a December hike surged and crossed the 70% level. Chart 1. US monthly non-farm payrolls and unemployment rate 350

5.8

5.7% 300

298

266

260

250

223 201

211

187

5.4

200 153 150

5.2

145

119

%

Thousands

5.6 245

5.0

100

5.0% 4.8

50 0

4.6 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15

 

monthy payroll additions (LHS)

Source: Datastream, US Bureau of Labour Statistics, December 2015

Unemployment rate (%) (RHS)

 

WHY HIGHER RATES MATTER FOR EQUITY INVESTORS? The outlook for interest rates matters for US equity investors for a variety of reasons. Higher policy rates translate into higher bond yields and higher borrowing costs, implying a less favourable credit environment. From an equity valuation perspective, higher policy rates and Treasury yields tend to imply both a higher ‘risk-free rate’ and a higher discount rate applied to future cash flows - other things being equal, these imply lower valuation multiples. In addition, there is always the risk of policy error, where it later transpires the central bank has pressed on the brakes too early. This was notably the case in 1936, for example, when the Fed raised rates prematurely, contributing to a collapse in asset prices, and a policy U-turn in 1937-38. BUT ARE CONCERNS JUSTIFIED? THE CASE FOR A SMOOTH TRANSITION While investor concerns regarding the outlook for US rates are understandable, a number of factors suggest that fears may be exaggerated. Financial conditions have already been tightening - As depicted in Chart 2 below, US financial conditions have already been tightening for the past 18 months. This has been mainly on account of the strengthening US dollar but also because of some widening in credit spreads. This is relevant because financial conditions typically tighten when US rates rise. However, it is clear that despite the tightening of financial conditions to date, there has been no discernible adverse impact on US equity performance with the S&P 500 index up by 11% since May 2014.

“A US interest rate rise is likely before year end, but it’s hard to see anything but a slow and steady approach to “normalisation”. If markets are right, this would be the most gradual tightening cycle ever seen in the inflation targeting era.” Andrew Wells, CIO Fixed Income

Chart 2. US financial conditions tighter conditions since mid-2014

2.5 Financial conditions index

2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 2010

2011

2012

2013

2014

2015

2016

Source: Gerard Minack, November 2015; * note higher numbers indicate tighter financial conditions and vice versa

Rate rises will be gradual - In the past three decades, US rate hiking cycles have typically occurred in times of unequivocally rising inflationary pressures and robust global economic growth. However, although signs of US wage growth have been emerging recently, overall inflation is still very low (essentially fluctuating around zero since the start 2015) while the global economy is far from robust, with less than half of the world’s largest 40 economies seeing rising leading indicators in the past 6 months. This strongly suggests that the pace of US monetary tightening will be more gradual than usually is the case. Indeed Federal Reserve Vice Chair Stanley Fischer recently opined that the pace of rate hikes will probably be more akin to a ‘crawl’ than a ‘lift-off’. Further adding to a likely preference for caution and gradualism will be the experiences of 1994, when the Fed was widely perceived to have raised rates too quickly with harmful results, and 1936, when it transpired it should not have raised rates at all. Rates will probably peak at a relatively low level - From the long-term equity investor perspective, what matters more than the precise timing of the first US policy rate increase is not just the speed with which rates will rise but where they will finally settle at the end of the tightening cycle. In this regard, it is notable that Fed members’ own estimates for the long-run (i.e. beyond 2018) steady rate, or ‘terminal rate’, have been coming down steadily from the median expectation of 4% in 2014 to 3.25% in the most recent Fed ‘dot-plot’ projections, with only modest expected tightening of 100bps in both 2016 and 2017. Market expectations for the pace of Fed tightening are even lower.

“Income-seeking investors will clearly be concerned about the potential for the Federal Reserve to begin tightening monetary policy and I would expect some volatility in markets around rate rises. However, such rises are likely to be slow and gradual.” Eugene Philalithis, Portfolio Manager

In addition to this, there is also the pattern of the last 45 years to consider as depicted in Chart 4. This shows that policy rate trough periods have been becoming longer and ratehiking episodes have been concluded at successively lower peak levels in real terms. Chart 3. Successively lower peaks for the real Fed Fund Rate 10

Real Federal Funds Rate

8

Federal Funds Rate minus 5-yr average headline CPI (blue line)

6

%

4 2 0 -2 28M

39M

93M -4 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Source: Federal Reserve, BLS, NBER, Minack Advisors. November 2015

Structural downforces on rates - Aside from the trend of past rate rising cycles and the Fed’s own and market expectations alluded to above, some important structural arguments can also be made for US interest rates staying generally low compared to history. In particular, there is a growing body of evidence that suggests that global savings are 1 structurally high owing to factors such as ageing populations and China’s structural current account surpluses, which in economic terms are the equivalent of excess domestic saving. On the other hand, global investment demand is also structurally low, due to factors such as the declining relative price of investment goods and today’s companies becoming less capital intensive, as depicted below. With high saving and low investment, the logical conclusion is that interest rates which we know equilibrate savings supply and investment demand, must also be structurally low. Secular stagnation, the saving glut and low interest rates

Source: Fidelity International, December 2015

Past evidence - While the usual caveats about the past not necessarily resembling the future should always be borne in mind, the historical evidence makes perhaps the most persuasive case of all:

“The Fed has so far been appropriately pragmatic in its decision making, and has tried to manage market participants’ expectations as carefully as possible. A widely anticipated rate hike has been well flagged, and therefore shouldn’t come as a shock to the market.” Angel Agudo, Portfolio Manager

  

In the one year leading up to the first rate hike, US equities have risen appreciably on each of the last four occasions, with an average rise of 17%. In the period soon after the first rate hike, volatility typically spikes and short term corrections are possible. As Chart 4 shows, in the one year after the first rate hike, returns were also positive in all of the last four instances with an average rise of 6.8% in these periods.

The most likely explanation for the frequently good performance of equities in both the one year leading up to and the one year following the first US rate hike is solid economic growth. Indeed, in terms of the last four rate hike episodes, it is worth noting that quarterly US real GDP growth averaged 4.3% one year ahead of the rate hikes and 4.2% one year 2 after the first US rate hike. Chart 4. One-year S&P 500 performance after first US rate rise 30th June 1999

1800

12

30th June 2004 1600 10

+6.0% +4.4%

4th Feb 1994

1200

8

1000 800

11th Feb 1988

6

+2.4%

600 400

4

+14.3% 2

200 0 0 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

S&P 500 Composite

Post-Hike Annual Return

Fed Funds Target Rate

Source: Fidelity International, December 2015

CONCLUSION After an unprecedented period of virtually zero interest rates, investors are understandably anxious about the possible negative equity market impact of rising US policy rates. However, it is worth remembering that rate rises are on the horizon only because the US economic recovery is judged to be sufficiently robust. In addition, what matters more from the real economy and long term investor perspective is not the precise date of the first small rate hike from a historically low base, but the likely trajectory and end-point of rates. In this respect, with US inflation very low, global growth still lacklustre and the risk of a 1994-style policy error a real concern, all the signs suggest the Fed will adopt a very gradualist approach to rate rises, more akin to ‘crawl’ rather than a ‘lift-off’ along with a significantly lower terminal rate compared to past cycles. Based on the Fed’s own latest projections, the Federal Funds Rate will not reach the 2.0% level until 2017. In addition, the influential savings-glut/weak investment demand arguments provide a persuasive rationale for structurally low real and nominal interest rates. Finally, whenever rates do rise, past experience shows that US equities tend often to rise significantly ahead of the first rate rise – and although volatility picks up soon after the first hike – the US stock market was materially higher one year after the first rate hike in each of the last four hiking episodes. With the easing of uncertainty that a rate rise may also bring, the case for the US equity bull market not being derailed imminently appears good.

“US consumption will easily be able to weather the expected modest interest rate increases and the domestic economy may well turn out to post a surprisingly strong performance.”

Dominic Rossi, CIO Equities

 

Fed Funds Target Rate

S&P 500 Index level

1400

 

 

REFERENCES 1. ‘The global savings glut and the US current account deficit’, Ben Bernanke, March 2005 2. Real GDP growth figures quoted are averages of annualised quarterly rates. The one-year ahead average figure includes the quarter in which the first rate hike took place. The one-year post figure refers to the four quarters following the quarter in which the first rate hike took place.

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