Valentijn van Nuiewenhuijzwen, head of multi-asset at NN Investment Partners, considers the market impact of the US Federal Reserve rate rise yesterday.
After a year of talking about it we finally got it. The Fed starts hiking rates for the first time in more than nine years. It has been long anticipated, so one has to wonder what it will actually mean if everybody had so much time to prepare for it. Probably not too much actually. It has been talked about for the whole year, was very well flagged in recent months and is close to fully “priced” by the market. Therefore it can certainly not be excluded that it will be one of the most discussed “non-events” in terms of impact in the history of financial markets.
Markets reacted positively. On Wall Street, the Dow Jones ended Wednesday with gains of 1.28 percent, while the S&P 500 rose 1.45 percent and the Nasdaq 1.52 percent. Asian equity markets rose as well today while European equities opened considerably higher this morning. The US dollar rose slightly versus the euro and other currencies while moves in the Treasury market were also modest.
As widely expected, the Fed announced a 25 basis point hike in the federal funds rate following the December gathering of its policy-making Federal Open Market Committee (FOMC), bringing the target to 0.25–0.5 percent. In the statement accompanying the central bank’s unanimous decision, the Fed cited considerable improvement in labour market conditions and a reasonable confidence that inflation will approach its 2 percent objective over the medium term. It also noted that its monetary policy stance remains “accommodative” despite the increase. The central bank made clear the rate hike was a tentative beginning to a “gradual” tightening cycle, and that in deciding its next move it would put a premium on monitoring inflation, which remains mired below target. Fed officials do not expect inflation to reach the central bank’s 2 percent objective until 2018; core PCE, the Fed’s preferred inflation metric, grew only 1.3 percent in October from a year earlier.
With an initial increase out of the way, attention will turn to the trajectory of the rate hike cycle and its terminal level. Messaging from the statement suggested the central bank remains generally dovish on these points. Fed policymakers’ median projected target interest rate for 2016 remained 1.375 percent, implying four quarter-point hikes next year. We however expect three hikes in 2016.
Other factors more dominant for markets than a Fed hike
It should be foolish to ignore the risks that are hiding in the tails of this Fed decision. A whole generation of traders and fund managers have never seen the most influential central bank in the world hike rate. In a market environment full of heterogeneous players the formation of expectations, and thereby the evolution of market prices, can be highly erratic and irrational around such “rare” events as a Fed rate hike. Shortly put, action always speaks louder than words (even if Draghi makes us doubt sometimes) and once the Fed move finally arrives the behaviour of the market can always surprise compared to whatever expectations had been built up beforehand.
Meanwhile, it also has to be acknowledged that many other factors seen to have been more dominant than the Fed for the mood in markets in the last part of the year. Maybe even for most of the full year. The ECB certainly stole the Fed’s limelight this year in terms of setting central banking themes that influenced the markets most strongly. Both equity and bond markets have been more impacted by the ECB’s QE package, the technical sell-off in Bunds that followed on a QE driven rally in Q1 and the surprising inability of Draghi to surprise markets positively indefinitely.
Another key factor this year was the deteriorating growth outlook for the Chinese economy and the unexpected devaluation of the Chinese currency. Especially since this added to already troublesome dynamic in other parts of the emerging world. Moreover, the sharp declines in oil and commodity prices as a result of weak demand (read: China) and lack of supply side discipline (read: OPEC and shale oil/gas revolution) were probably also more important swing factors for market sentiment this year than the Fed ever became.
Therefore we got a year full of volatility on the back of these dynamics and relatively modest returns. The good thing is that this has pushed the talk of bubbles to the background again as equities are close to the levels at the start of the year, credit spreads are wider and bond yields are higher. Obviously, further market turmoil surrounding the Fed announcement could keep risk premiums elevated for some more time, but at their current levels it certainly seems that a big part of the risks around us has already been priced by markets.
Equities back to overweight
In combination with cash yields close to zero almost everywhere, it means that we feel that markets still offer much better investment prospects than holding cash as we head into 2016. Especially since we think that resilience in DM domestic demand will remain a steady anchor for the global economy next year.
Therefore, we actually think the latest bout of market volatility on the back of renewed downward pressure on oil prices (and a disappointing Draghi) creates an opportunity to add a bit of tactical risk to our allocation stance.
As a result we moved equities back to a small overweight. Moreover, we balanced the underweights towards the areas of the markets that are most exposed to commodity and EM stress by bringing both fixed income spreads and commodities to a small underweight.