Don’t fear a Fed hike: It’s unlikely to cause chaos

Central banks are now much better at communicating their intentions
and

and steady rate rises mean that tightening policy probably won’t hurt your portfolio

THE FOURTH of February 1994 is a day I remember well. Six months into my first job as a macro economist with an institutional fund manager, I got my first experience of how investors and markets react when they are surprised or, in this case, spooked.

That day, the US central bank – the Federal Reserve – unexpectedly raised interest rates by 0.25 per cent, the first increase since 1989 and two years since they were last cut, to 3 per cent. In the next three months, holding a long-term US government bond would have cost you more than 10 per cent. In the relatively “safe” world of government bonds, this was carnage. A holder of UK government bonds would have gone through a similar experience.

Since then, much has changed in how markets work, and how central banks communicate their intentions. Now, investors should not be surprised that rates will be going up; maybe this month, perhaps October, but definitely soon.

THE FED’S DILEMMA
It is not an exaggeration to say that every part of the global financial system – and that includes the mortgage rate you pay here in the UK – is affected by what the Federal Reserve says and does.

Cogent arguments have been made for and against raising interest rates now. In very simple terms: the US unemployment rate is low and continues to fall so, as a result, inflation will re-appear at some point. Alternatively, low inflation means the Fed can be patient in raising borrowing costs and, with emerging markets going through a period of instability, the risks for the rest of the world from higher US rates are considerable.

KEY RISKS
What matters for investors is not just the start date, but how far and fast interest rates will increase. The size of the hike (we think the Fed will start small, adding 0.125 per cent) and how the central bank communicates its reasons for raising rates are important information for investors.

Herd behaviour may lead to more volatility once the Fed starts. If everyone is worried about higher interest rates, shouldn’t I be too? We would be more concerned if the Fed signalled a desire to start unwinding its bond holdings from quantitative easing, but that still seems a way off.

In our opinion, the key risk lies in the developing world. Even with a cautious Federal Reserve raising interest rates very slowly and steadily to something like a “normal” level, perhaps 2 to 3 per cent, the risk is that money flowing out of emerging markets leads to a pernicious sell-off across asset classes.

EFFECT ON PORTFOLIOS
But should a rate increase be so bad for equity markets beyond the short term? History shows us that an environment of rising interest rates does not mean that equity markets cannot perform well. Even in 1994, equity markets managed to produce a positive return. It is not until higher rates start to bite and slow growth materially that equities suffer.

In our clients’ portfolios, we are defensive in bond holdings and hold very little in emerging markets (less than 3 per cent in our highest risk portfolios). And we are a bit more cautious over smaller company stocks, particularly here in the UK after a very good run. But the outlook for stocks still looks very good to us – notably in Europe and Japan.

The fundamental story of a global economic recovery, supported by very low interest rates and a much lower oil price, will still be intact after the Fed raises rates. And holding off the first hike too long may actually be bad for sentiment: does the Fed know something we don’t?

My message to the Fed? Go on, press the button. It will be OK on the other side.

Shaun Port is chief investment officer at Nutmeg.