Global Equity Strategy - The impact of the first Fed rate hike


We think the purpose of the Fed rate hike this time is more benign than usual: It is to insure against financial asset bubbles and to create room for easing into the next recession, not to control inflation by slowing down growth.

We have never seen such a de-synchronised monetary cycle globally; the first Fed hike has never happened so late into the US economic/profit cycle; and the Fed historically has started tightening when ISM new orders were closer to 60, compared to 48.9 currently.

The first Fed rate hike has historically caused a correction of c7% in equities, though it has never marked the end of a bull market. The US has always underperformed in the six months following the first rate hike. GEM equities are already discounting a 1% Fed funds rate. The most vulnerable currencies are the Rand and the Lira.

The impact of the first Fed rate hike
The interest rate futures curve is pricing in an 80% probability of the Federal Reserve raising rates on 16 December, which would represent the first rate rise in nine-and-ahalf years (the last was in June 2006), and the first time in seven years that rates have been above zero.

When do rate hikes really matter?
In our view, the impact rate hikes have on financial markets depends on their underlying rationale. Historically, the main motivation for raising rates has been to reduce inflationary pressure by slowing growth below trend.

We think that the motivation behind the Fed's likely decision to hike on this occasion is two-fold:
(1) To forestall the potential formation of an asset bubble in real estate or equities, and reduce the misallocation of capital,

(2) to move away from the zero-bound rate and create monetary flexibility in a future downturn, with the Fed Funds rate currently abnormally low relative to real GDP growth.

Crucially, the first Fed rate hike of this cycle is not, in our view, designed to control incipient inflationary concerns or to slow growth. We believe that trend growth in the US is around 1.5-2.0% (i.e., the rate of growth of the labour force plus productivity growth), which compares with the 2.5% growth seen in the past two years. However, we think there is still spare capacity in the economy that could justify above trend growth for longer.

Inflation is not a problem in our mind until either wage growth rises to 3.5% YoY or unemployment falls to levels associated with full employment, which in our view is around 4%-4.5%. Currently wages are growing by c.2.3% YoY and the unemployment rate is at 5%.

We believe monetary tightening only becomes a bear market signal when:
(1) The economy hits full employment or wage growth hits a level associated with the Fed having to drive GDP growth down to trend. This would require the Fed to engage in more aggressive tightening of monetary policy,

(2) when the yield curve inverts, which will be a potential signal of a recession, and

(3) when real bond yields rise to a level that means that the US can no longer stabilise government debt to GDP and unemployment (this would be a TIPS yield above c1.2% on our analysis).

What’s different this time around?
We have never seen such a desynchronised monetary cycle globally; the first Fed hike has never happened so late into the US economic/profit cycle; and the Fed historically has started tightening when ISM new orders were closer to 60, vs 48.9 currently.

A signal for tactical caution on equities
The first Fed rate hike has historically caused a correction of c7% in equities (and there are plenty of other warning signals on US equities currently), though it has never marked the end of a bull market (six months later equities are, on average, up 2.2% from pre-Fed tightening levels).

Regional performance
The US has always underperformed in the six months following the first rate hike. GEM equities are already discounting a 1% Fed funds rate. The most vulnerable currencies are: the Rand and the Lira.

Bond yields
Apart from 2004, bond yields have typically risen after the Fed hikes. Currently, the market is 70 bp more optimistic than the Fed for end 2016.

Dollar
The USD has peaked after the first Fed rate hike in the last five cycles and the dollar is already up 40% in trade-weighted terms, the same as the previous bull market. Thus, we see only modest dollar strength from here.

Sectors
Cyclicals typically outperformed in the six to eight months after the previous first rate hike. This time, we are at a later stage of the economic cycle in the US and an earlier stage in Europe, and thus we would focus on our preferred European cyclical plays: Auto components, employment agencies, software and advertising agencies. This time financials also seem a better play on Fed tightening than cyclicals (e.g. Pru and Axa). Sectors with a positive correlation to two-year note yields and low financial leverage are semis and hardware.

Growth
Has outperformed in two out of the past three Fed tightening cycles and we think can do so again.

Losers
Highly leveraged bond proxy sectors, of which we find UK REITs, European consumer staples and US utilities among the most expensive. (Read Report)

Source : Credit Suisse Asia Pacific Equity Research

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