So they finally did it. On 16 December 2015 the US Federal Reserve (Fed) lifted interest rates off the ‘zero bound’ to 0.5%. Speculation and commentary had reached fever pitch in the run-up. However, those expecting relief from chatter may yet be disappointed now that further variables under the Fed’s control will open themselves up to scrutiny, including the speed, steepness and final destination of the interest rate cycle. For investors, the start of that new cycle should merit some careful thought since asset prices have enjoyed the natural floor of strong US policy stimulus for over six years. We believe that is now ending.
Past evidence suggests investors should not be unduly concerned about opening rate rises. Four of the last eight major interest rate cycles saw the S&P 500 climb, with an average gain over all eight cycles of 3.5%. While other factors beyond just interest rates undoubtedly come into play over any given 12-month period of equity market performance, there is nothing to suggest that rate rises have historically been a bad thing for equities. But today’s assessment may need to rely less on the past.
Years of stimulus packages, quantitative easing and low interest rates have distorted traditional perceptions of risk and reward. With the risk-free rates offered by cash and bonds so low for so long, investors were prepared to bid up equities and wait for economic recovery.
At the end of 2015, the S&P 500 was trading at a price / earnings ratio of 18.3x, compared with a 10-year average of 16.5x. But today, earnings are under unique pressure from a combination of the strong US dollar, depressed energy prices, rising wages and stubborn consumer caution. And higher interest rates are coming towards the end of the corporate earnings cycle rather than at the start or in the middle of it as conventional wisdom dictates.
The higher government bond yields that often go hand in hand with tighter monetary policy only add to equities’ woes because they compress the relative attraction of equities over bonds as encapsulated in the equity risk premium (ERP). Since early 2014 the ERP has hovered around the 4% points mark.
Equity impact from start of rate cycle has on average been positive
31 December 1969 to 31 May 2005
But it’s those investments lying at the outer boundaries of liquidity and risk which give the most cause for concern. In corporate credit, high yield bonds have made significant gains from the post-GFC (global financial crisis) nadir in 2009 but the market was highly volatile in the last quarter of 2015, with December’s spreads widening out to levels not seen since the summer of 2012. Legitimate concerns over liquidity and high exposure to beleaguered energy-related companies have tarnished what was seen as an easy way to access higher returns.
Emerging market bonds are another area to watch carefully. According to the Bank for International Settlements (BIS), emerging market non-financial private sector borrowing has jumped from 60% of GDP in 1997 to 120% at the end of 2014. The reasons for this are clear: low returns in the US saw investors pour into emerging market corporate bonds which offered higher yields, while emerging market companies were only too glad to take advantage of comparatively low lending rates. As the US rate rise approached and it became obvious that a new monetary policy cycle was about to begin, this process started to reverse in 2015, with emerging market bonds (as well as equities and currencies) coming under pressure. The era of “abundant bond financing”, as the BIS describes it, is probably coming to an end and the unwinding will be unpleasant.
The US dollar is of particular interest this time around because its continued ascent was one of the main stories of 2015. Historical evidence over the past eight cycles suggests that dollar gains have on average eased off after the first rate hike. But again, history may not be informative. We are now in a unique situation of the US Federal Reserve tightening monetary policy while other central banks of large economies are scrambling to loosen theirs. The eurozone has negative interest rates and, for as long as growth and inflation forecasts are weak, quantitative easing there is likely to cap the yield available from the bloc’s core bonds.
US dollar on average over the last eight cycles has slightly weakened following the first rate hike
31 January 1972 to 31 May 2005
According to another recent report by the BIS, nearly EUR 2 trillion of eurozone government bonds trade with negative yields. Simultaneously, 10-year US Treasuries yielded over 2% as at end 2015 and might reasonably rise in the coming months. This makes for an attractive premium over European and Japanese bonds, which act as a magnet for global capital and push up demand for US dollars. Interestingly, when the ECB began its quantitative easing programme the US dollar index began to closely follow the yield gap between US Treasuries and their European and Japanese counterparts. Aside from occasional short covering rallies, it does not feel like the euro will be able to make meaningful progress against the US dollar any time soon. Away from Europe, China is also working to devalue its currency against the dollar given its slowing economy and the non-option that is wage deflation there. Other emerging market currencies are also likely to remain under downward pressure against the dollar in light of the huge debt burden.
Widening gap between US Treasuries and bunds, JGBs could drive US dollar from here
31 December 2012 to 31 December 2015
With equities under pressure and higher yielding and emerging markets bonds vulnerable, new approaches aiming to generate positive returns from capital markets will be required. The period from 2009 to 2014 is starting to look like a classic buy-and-hold era in equities and bonds. But that has come to an end. We believe positive returns will be elusive if the same strategy is repeated in 2016. Highly flexible asset allocation and sophisticated target return approaches are likely to make more sense. While it’s tempting to believe that experienced and skilled investors can asset allocate their way to absolute returns over short to medium horizons, the penalty for making the wrong call will be large. Instead, the higher probability of risk-adjusted success may lie with a basket of high conviction, market-agnostic relative value trades diversified across a range of risk factors. For some, this will seem like a radical change in approach after the apparent vindication of buy and hold since 2009. But it should also be borne in mind that this first Fed rate hike is likely to prompt a more profound reassessment of the investment landscape than any before it.