US interest rates have been tethered to record lows for the last six years. When rates were originally cut to these levels, they were predicted to return to normal within a year. Six years later, we’re still waiting.
But at the Federal Reserve’s latest meeting, the US central bank dropped its pledge to be “patient” before raising interest rates, opening the door to the first rise in official borrowing costs in nearly a decade.
With the Fed meeting once again this week and as we move towards the ‘normalisation’ of US monetary policy, investors are understandably keen to see what the impact will be on individual assets. Mike Turner, head of Multi-Asset Funds, looks at the potential impact on various asset classes.
Even before any rate rises have taken place, the most obvious beneficiary has been the US dollar. The currency has risen more than 12% this year on a trade-weighted basis, reflecting expectations of a rate rise at a time when two of the world’s other major central banks (the ECB and BoJ) are easing policy.
However, this has created something of a herd mentality and we may see that when a rate rise does eventually materialise, that it has been fully priced in to currency markets. After all, when rates do start to go up they will probably do so only gradually.
Developed market equities
One of the effects of the US dollar’s surge has been to effectively tighten financial conditions by lowering import prices and reducing US export competitiveness. Although recent corporate profits announcements have been encouraging, analysts have been cutting forecasts for future earnings.
Amid rising share prices, future valuations have become less appealing. Furthermore, given the miserly payouts available from bonds and cash (in a growing number of cases yields are now negative), investors have been taking increasingly large positions in equities.
As a result, any unexpected bad news, including bigger-than-expected rate rises, could hit equity markets disproportionately hard.
Emerging markets equities
Emerging markets with currency links to the US dollar have already felt the impact of its strength. Some risk remains, although the relative underperformance of many emerging countries has created some attractive-looking valuations and possible investment opportunities.
Increasingly with emerging markets, it’s important to adopt a more ‘granular’ approach, making decisions on a country-by-country basis. It no longer feels as relevant to talk about “emerging markets” as a single entity. There is an array of factors affecting different emerging markets in different ways. Dollar strength is just one of these factors.
Expectations that interest rates will remain lower for longer increased the attraction of bonds slightly at the end of last year. In recent months, there have been some signs of 10-year Treasuries twitching higher, as investors have begun to anticipate the timing of the Federal Reserve’s first rate rise.
For now, the market’s focus is torn between the effects of significant central bank easing, which should cause gaps between similarly rated government yields to narrow, versus the perception that the economic decoupling of the US from most of the developed world will lead to higher US bond yields.
Although investment grade corporate bonds have continued to benefit from investors’ hunt for yield, the extra risk involved in high yield bonds proved a step too far for many investors towards the end of last year.
The fall in the oil price was principally to blame, particularly in the US, where the junk bond market contains a relatively high number of shale producers. That said, the market has turned around in recent weeks, propelled by the increasingly vigorous search for yield.
For those investors that are wary of taking too much exposure to equities and are concerned by the overvaluation of bonds, there are still opportunities to make money. Increasingly though they are having to search new horizons.
We have favoured an overweight position in commercial property throughout the last year, which has served us well. It’s proving more difficult to find attractively priced properties, but given the level of yields on commercial property compared to government bonds, this is a position we are happy to maintain for the time being.
We remain bearish towards commodities though, which appear likely to remain depressed by slowing Chinese growth.
Our current forecasts point to an increase in US rates at Fed meetings in June or September, though the pace at which they are raised is now data dependent. In particular, there will need to be further improvement in the labour market and the Fed will have to be confident that inflation will move back to its 2% target in the medium term.
Despite this likely rise in US rates, the investment environment remains one of historically low inflation, low yields and low interest rates.
When seeking returns in such an environment, we would emphasise the benefits of diversification and the importance of holding assets with a lack of correlation to both bonds and equities.
Whether investors’ needs are slanted towards income, growth or capital preservation, the need to invest via a well-balanced, diversified portfolio is becoming increasingly apparent.