After nine years the Fed breakthrough has arrived. In December, the American Central Bank initiated a rise in interest rates with an increase in the cost of money by 25 basis points, bringing the reference range to 0,25%-0,5% from 0-0,25%. The decision, taken with a unanimous vote by FOMC members, marks the first rate hike since 2006 and puts an end to the era of free money linked to the subprime crisis that erupted in 2008. The immediate impact on markets was limitedgradual tightening was widely expected and fully discounted across all asset classes. However, even if this historic Fed rate hike appears to have passed on the sly, for some the calm in the markets is unlikely to last long. What does all this mean for stock markets and investments?
THE SLOW RISE OF RATES
WATCH OUT FOR VOLATILITY
Per Yuchen Xia, portfolio manager of MoneyFarm, the rate hike represents "good news for investors, as well as evidence of positive economic prospects for the United States". However, she cautions, “The real challenge is yet to come”, because financial markets are not immune to volatility and 2015 was proof of this. “The increasingly evident political divergence between the United States and the ECB and the geopolitical tensions of recent months – commented Xia – could cause volatility on the markets also in 2016, making the path of future rate increases even more delicate as well as the real challenge to overcome".
In fact, the focus is now on the pace and timing of the further restrictions. The consensus of analysts indicates three rate hikes in the next year but there are those who assume the Fed will stop at two by another 25 basis points. Tighter monetary conditions as a result of the strong dollar and widening corporate spreads could act as a deterrent to more aggressive moves. However, there are also those who go so far as to foresee four rate hikes and those who believe it possible that the Central Bank could raise interest rates faster than what the market currently expects.
"There is nothing to be alarmed about," said Dennis Lockhart, Federal Reserve Governor of Atlanta. "It is not automatic" that monetary tightening will push the dollar upwards, he commented a few days ago in a radio interview, explaining that future rate hikes will depend on the performance of the US economy. Stanley Fischer, Fed vice chairman, also expressed the opinion that the pace of rate hikes will be more like a "slow climb" than a "take off". The rise in US rates, albeit gradual, could still accentuate the capital outflows we have already seen in emerging markets, with a weakening of exchange rates and a decline in the prices of their asset classes. “First of all and above all – he comments Chris Probyn, Chief Economist of State Street Global Advisors – for us the main effect will be a period of volatility”. In any case, once the go-ahead for normalization has been declared, which has removed a source of uncertainty on the markets, the attention of operators is also shifting to other issues such as low raw material prices or slow global growth.
SHARES, LOOK AT THE PROFITS
OIL, A RISK EVEN FOR EUROPE
While in general for stocks, rising interest rates are usually a slightly negative factor, it's important to remember that the Fed will hike rates again if it believes the economy is resilient enough to sustain the hike. “If the economy is resilient – he always points out Probyn of State Street Global Advisors – then earnings growth should be acceptable.
Christophe Donay, head of asset allocation and macroeconomic research at Pictet Wealth Management corporate earnings expansion in 2016 is not expected to exceed 5% for the S&P 500. Given the lack of momentum for economic growth, corporate earnings expansion and stretched valuations “return potential for developed equity markets – he says – it will be limited, around 7%-10% (dividends included). European equities should outperform US equities as the economic recovery in the eurozone is still at a less advanced stage and monetary policy provides more support.
On the other hand, US equities have already strung together six years of positive performance as US corporate debt levels have increased. “And – explain the experts of Dnca – represent a risk to the prices of risky assets in the event of the Fed's poor management of the yield curve. Global price competition through a generalized devaluation of major currencies weighs on the growth curve of the earnings of US companies”. Dnca has identified three themes for equity investments which are concentrated in the Euro area: companies operating on the domestic market exposed to the recovery of European consumption; companies undergoing restructuring/involved in mergers and acquisitions; growth profiles independent of the world cycle.
Lhe outperformance of the European equity market was once again a dominant theme in 2015. But it is not without surprises. “In our view the Eurozone should grow above its potential, but this idea is so widespread that disappointment is lurking,” he underlined Pierre Olivier Beffy, Chief Economist of Exane BNP Paribas indicating that Europe is the area most exposed to the American slowdown and to a crisis in emerging countries on which the negative impact of the drop in oil is increasing. "The marginal benefit deriving from the weakness of crude oil is significantly decreasing, while the negative impact on emerging economies is increasing", Beffy always noted, hoping for 2016 a stabilization or a possible rise in oil prices that would give relief to the American oil sector and to countries exporting black gold.
