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What will a U.S. rate rise this week mean for stock markets?

In the aftermath of the financial crisis, the actions (and investor’s expectations of future actions) of Central banks such as the US Federal Reserve Bank (Fed), Bank of England, European Central Bank and Bank of Japan have arguably been the dominant factor driving the direction of global equity markets. Where monetary policy has been loose, with interest rates slashed and the money supply expanded through so-called Quantitative Easing programmes, the relentless gush of liquidity has helped turbo-charge financial assets such as bonds and equities.

Jason Hollands Jason Hollands
14 December 2015

So, with the mighty Fed now widely expected to announce the first rise in U.S. interest rates since June 2006 on 16 December, finally bringing an end to over a year of “will they, won’t they” debate among market watchers, investors will understandably be asking “what might this might mean for my portfolio?”

A U.S. rate hike is priced in….

The first thing to understand is that markets have almost certainly priced in a rise in U.S. interest rates. The desire to raise them, subject to the economic data meeting certain criteria, has been repeatedly flagged by Fed officials. In a speech last week, Chairwoman Janet Yellen delivered an upbeat assessment of the U.S. economy, expressing “confidence in a return of inflation”, which was widely interpreted as “we’re still on for a hike”. According to Bloomberg, traders see a 76% probability of a rate rise. With an interest rate hike factored in, markets may actually respond well or indifferently to any news itself as it removes an uncertainty. If anything, the risk now could be that an excessively dovish announcement might spook markets as many participants seem to be pricing in a normal rate hiking cycle.

Of course, never say never; we have almost been here before. At one time a ‘lift off’ for U.S. interest rates had been pencilled in by many observers for September, but global market jitters on the back of poor data from China, the unwinding of its equity market bubble and concerns about a deflationary shock wave put a rate rise on hold. This time round, however, there is a sense that it would take a really major shock between now and next week’s meeting of the Federal Reserve Open Market Committee to keep rate hikes on ice again.

Growing expectations of a U.S. interest rate rise have already nudged borrowing costs, in the form of bond yields, higher and have also been the hidden hand that has spurred a strengthening of the U.S dollar versus other major currencies, including the euro, where low interest rates look set to continue for some time yet. Last week the European Central Bank announced an extension of its €60 billion a month QE stimulus programme until at least March 2017 or until inflation reaches the ECB's target of below or close to 2%.

The prospects of higher U.S. borrowing costs and the accompanying strength of the US dollar have also been reflected in the gruelling pressure on emerging market currencies and markets during 2015, especially those countries with high dollar-denominated borrowings where the costs of servicing such debt has become incredibly painful. For some of the countries that also have economies heavily exposed to commodities, oil and gas, 2015 has been an almost perfect storm. The rout in commodity and energy prices has been one of the dominant themes in markets during 2015, as oversupply and wilting demand from a slowdown in Chinese growth have combined.

A tougher environment for U.S. equities? It’s already begun but dollar strength has disguised it for UK investors

We do however believe investors need to tread with caution when it comes to U.S. equities, and are underweight the U.S. in our Multi-Asset Portfolio funds. U.S. shares enjoyed a meteoric run under years of rock bottom interest rates and successive rounds of Quantitative Easing programmes, with the S&P 500 Index soaring 103% over the last five years, outpacing the MSCI World Index by 21%.

While the U.S. economy is in a better shape than many, share prices have risen far faster than profits and earnings may have peaked. On a number of measures, U.S. share valuations look relatively expensive. One measure that compares share valuations to longer term history is the Cyclically Adjusted Price/Earnings Ratio, or CAPE for short. On this basis US shares are trading at around 26 times earnings, compared to a historic average level of 16.6 times. Over the entire history of the US market, it has been cheaper than where it is now around 64% of the time. While there is some debate over this, with some large financial institutions arguing U.S. shares are ‘fair value’ and others expensive, there’s an absence of anyone arguing the U.S. market is a bargain.

It only makes sense to pay a premium valuation today if you are convinced that the valuation will ultimately be more than justified by earnings accelerating. Yet there is scant evidence of this and the risks of a slowdown in global growth are mounting. The strong dollar could start to pinch U.S. exporters.

The other reason to be cautious about U.S. shares is that the bull market has been so heavily fuelled by the flow of liquidity from the Fed. Much of the earnings growth in recent years has been achieved through a combination of aggressive cost cutting and the ability of companies to re-finance debt on very attractive terms – there is only so much of this stuff a company can do. The significant expansion in earnings from this activity has enabled U.S. companies to buy-back their own shares, leading to stock price appreciation. According to estimates compiled by the Bank of International Settlements, some $2.1 trillion of non-financial equities have been bought back in the U.S. since 2009, a period over which corresponding net debt expanded by $1.8 trillion. Those heady days may now have already peaked, as bond yields have already edged higher.

Yet that game may start to have run its course: as we said earlier, US bond yields have already started to rise in anticipation of U.S. interest rate rises, meaning borrowing costs have been rising. There is already some evidence of a marginal slowdown in the rate of US company share buybacks, and as liquidity flows from the Fed reduce and buybacks slow, this will likely see the US market struggle to sustain its premium rating, especially as international investors continue to focus on those markets such as Europe, where easy money policies remain in place.

Does this mean the U.S. market is heading for a fall? Not necessarily, but it is has already stalled and might just trend sideways. In fact, in dollar terms the U.S. market had a dull 2015 pretty much treading water, but UK based investors in U.S. equity funds may not have noticed this as returns were massaged by exchange rate movements. If a future U.S. rate hiking cycle turns out to be more muted than expected, investors may not see such a currency boost repeated.

A bigger concern than U.S. rises themselves remains the slowdown in China, for years the engine of global growth, and the instability of its economic model. A raft of data from China has disappointed and the loss of momentum in its rate of growth has been the key swing factor in collapsing commodity prices, further pummelling certain emerging economies heavily exposed to raw material and oil and gas at a time when the strong dollar has added to the costs of servicing debt.

So what should investors do?

 

  • Investors who hold their exposure to the U.S. market through low cost S&P 500 Index trackers, as many do, might revisit this. While there is a lot of sense in this approach on a long-term view, if the U.S. bull-run is running out of steam, these funds will be less appealing and also very vulnerable to any correction. Investors might therefore want to use funds that are more sensitive to a company’s valuation. One such instrument is the Powershares FTSE RAFI US 1000 UCITS ETF, which invests in the 1,000 largest companies, but rather than weighting exposure to each on the basis of its size, it does so on a combination of fundamental attributes (revenue, cash flow, dividends and net assets on the balance sheet). This means it combines the benefits of passive investing (low costs, diversification) but leans away from more expensive, speculative companies in favour of more robust and reasonably valued ones. Investors looking for actively managed exposure might consider the Dodge & Cox Worldwide US Stock fund.
  • Across developed equity markets we prefer Europe. Despite the European Central Bank leaving markets somewhat underwhelmed by its recent announcement that it would extend its QE programme (markets had hope for more aggressive moves), Europe still has loose money policies in place with the scope to do more and, as the Eurozone is a net importer of oil and gas, continued low energy prices provide an additional economic boost to both businesses and consumers. European equity funds we like include Threadneedle European Select and small/mid cap focused Baring Europe Select.
  • Emerging Markets and Asia have been so underwhelming there comes a point when you have to ask whether the bad news and risk are priced in. Emerging Market equities are valued at around 10.8x their projected earnings which is a discount of around 30% to developed market equities. 2016 could be the year when investors might consider start dipping their toe back in with incremental purchases. Funds we like include Fidelity Emerging Markets and Newton Global Emerging Markets and for Asia ex Japan, the Stewart Investors Asia Pacific Leaders fund.

The value of investments, and the income derived from them, can go down as well as up and you can get back less than you originally invested. This press release does not constitute personal advice. If you are in doubt as to the suitability of an investment please contact one of our advisers. Past performance is not a guide to future performance.

Different funds may carry varying levels of risk depending on the geographical region and industry sector(s) in which they invest. You should make yourself aware of these specific risks prior to investing.

Targeted Absolute Return funds do not guarantee a positive return and you could get back less than you invested, as with any other investment. Additionally, the underlying assets of these funds generally use complex hedging techniques through the use of derivative products, which can carry additional risks which may not be immediately apparent.

ETFs can be high risk and complex and may not be suitable for retail investors, so you should make sure you understand all the risks involved before investing.

Underlying investments in emerging markets are generally less well-regulated than the UK. There is an increased chance of political and economic instability with less reliable custody, dealing and settlement arrangements. The market(s) can be less liquid. If a fund investing in markets is affected by currency exchange rates, the investment could both increase or decrease. These investments therefore carry more risk.