Since the end of last week, speculation has been mounting that the US Federal Reserve will raise interest rates again this year. The probability of a September rate raise looks slimmer after the Fed’s most dovish official, Lael Brainard, struck a cautionary tone in a speech yesterday. But there is a strong chance that the next phase of monetary tightening will begin in December, after the presidential election and one year after the Fed’s first rate rise since 2006.
With a jobs market approaching “full employment”, interest rate increases should stem the effects of the inflation which should, theoretically, follow. However, economic data have been mixed. Expenditure figures point to a strong rebound in GDP for the third quarter, while production-based business survey evidence is much less promising. “Softer recent data and political risk mean we don’t think the Fed will move until December,” says Charlie Diebel, head of rates at Aviva Investors.
Like their American counterpart, the Bank of England and European Central Bank (ECB) are also on standby, but any movements in their interest rates are likely to be cuts.
“Global policy divergence seems most profound between the Fed and the ECB, with central bankers facing in opposite directions,” says Steven Andrew, who manages the M&G Episode Income fund. The ECB may have held interest rates last week, but it is expected to cut them further into negative territory if Eurozone inflation and growth are still lagging in December.
Having cut interest rates to 0.25 per cent last month, the Bank of England has broken with the pre-Brexit expectation that it would follow the Fed in tightening. “The UK has had a fair amount of stimulus from the Bank to help support confidence, and the macroeconomic data hasn’t been too bad,” says Diebel. “It will now want to wait until Article 50 is triggered before it decides what support is needed.”
As rates diverge, and the dollar strengthens, here’s how investors can profit.
Emerging market fallout
Emerging markets have rallied over this year thanks to a weaker greenback, and may now see a reverse in their gains.
Having borrowed heavily in dollars during the years of cheap US credit which followed the financial crisis, a lot of corporate debt in developing economies will fall due over the next few years. As higher interest rates drive up the yield on US Treasuries, the return on emerging market dollar-denominated bonds are expected to fall sharply.
The pain, however, may not be as acute as with previous Fed hikes. “The path of monetary tightening should be more gradual and better signalled, with policy-makers mindful to tread carefully,” said Capital Economics’s Simon MacAdam. “What’s more, with larger foreign exchange reserves, smaller current account deficits, lower levels of external debt and generally floating exchange rates – which have already fallen a long way, emerging markets are more resilient to Fed tightening now than they were in the 1990s.”
Back the banks
Constrained by new liquidity rules, a rise in interest rates will bolster the performance of US bank equities by widening the spread between short-term and long-term lending rates and finally enabling them to boost their profits. Reluctant to alienate their customers, banks have have had their margins squeezed as interest rates have been held down.
At present, the cheap valuations of some US banks make them a bargain. The price to book value of Citigroup and Bank of America Merrill Lynch, for example, indicate that their shares are currently trading at a huge discount given the size of their assets.
Darius McDermott of Chelsea Financial Services also points to UK-listed banks, like HSBC, which earn much of their revenue in dollars, and inter-dealer brokers like Icap which are expected to profit from the market volatility which accompanies interest rate rises.
US valuations do not look cheap, he says, but UK investors in US equities, or UK stocks like BP which enjoy a large exposure to the US, are likely to benefit at a time when sterling is particularly weak.
A focus on the fiscal
And what for the markets like the UK and Eurozone where monetary policy remains loose?
“My sense is that even where monetary policy remains accommodative, we will start to see a recalibration of focus towards fiscal policy,” says Hollands. He recommends a defensive strategy which might include gold, absolute return funds and exposure to companies involved in infrastructure, through funds such as the Lazard Global Listed Infrastructure Equity fund.
“There’s a lot of talk in [UK] markets of a potential shift to fiscal support,” says Diebel. “But we won’t know anything until the Autumn Statement on 23 November.”