Seven years after, exactly
On December 16, 2008, the Federal Reserve brought the Fed funds target rate down from 1% to an historical low of 0.25%. On the same date, but a long seven years after, monetary authorities have become confident enough about the economic outlook to decide that time has come to conclude an extraordinarily long era of rates at a rock bottom level. The last time they initiated a rate hike cycle was … eleven years ago and the last rate hike occurred nine years ago, in June 2006.
Despite the fact that there was consensus expectation for a “dovish rate hike”, financial markets are celebrating (stock markets up, bond yields staying more or less stable and the US dollar gain is moderate). They are reassured by Janet Yellen comments such as “the pace of future rate increases will be gradual”. She has used this word a dozen times in her press conference.
Bond yields set to rise gradually over the next 12 months
In the US, favourable domestic demand trends and a progressive unwinding of the base effects related to the past slump in the oil price should drive headline inflation from its current 0.5% rate towards the level of core inflation (currently standing at 2%). As a result, bond yields are expected to rise. Because global growth will stay sub-par and surplus savings will remain persistent, we see the 10-year Treasury yield rising moderately, to 2.60% within the next 12 months. This will create gravitational pull on global bond markets even though the other main central banks (outside of the Bank of England) will either keep very expansive monetary policies or even become more accommodative. The 10-year Bund yield should thus be dragged up to 0.9% by the end of 2016. Investors should focus their investments in the fixed income space on non-government bonds (and in developed markets).
Stocks to beat bonds
Investors worried that yesterday’s rate hike is a prelude to difficult times in equity markets should pay attention to historical evidence. Looking back over the last 65 years, i.e. over a period that has seen eleven tightening cycles, equities have performed positively over the following 3, 6, and 12 months. Interestingly, the lower the starting point of the first Fed rate hike and the better is the return of equities in the following months.
Generally speaking, a strong rise in earnings drives returns and more than compensates for some de-rating. This is the norm. We would however go along with Mark Twain when he said that “history doesn’t repeat itself, but it does rhyme”. We believe that in the current cycle, earnings will be a less powerful contributor to performance as they are likely to grow at only a single-digit pace (particularly in the US where margins have no more room to expand) but valuations on the other hand have a good chance of behaving in a more favourable manner, by staying stable. Three reasons for this: the rate hike cycle will be very gradual, monetary conditions will stay very accommodative on a global basis and alternative assets, such as cash or bonds, are very expensive.
In a world in which fundamentals move very slowly, but a least in the right direction, we recommend investors to look for exposure on cyclical sectors on a selective basis. In concrete terms, we would concentrate on sectors that offer exposure to the positive domestic demand trends that we see in developed countries, to the detriment of commodity and emerging market related sectors.
Marginal upside for the US dollar
History does not provide strong hints in terms of what should be expected from the US dollar after the rate hike cycle begins. We would argue that most of the gains are already behind. There is however still some room left for appreciation as divergences between central banks widen. By the end of 2016, we see the US dollar around 1.05 against the euro and around 134 against the yen.
We retain our view that the global economy will continue expanding, at a sub-par pace, and that inflationary pressures will gain some strength but without jeopardizing a lowflation environment. In such circumstances, risk assets have room to perform positively.