One of the more surprising happenings in a third quarter full of surprising happenings is the resilience of the September FOMC meeting as a candidate for Fed lift-off. Amidst market volatility, global equities have sold off by over 7% quarter-to-date – led by emerging markets (EM) at -19%, followed by Japan, Europe and the US at -12%, -6% and -5%, respectively. Still, the odds are small but non-trivial that a Fed rate hike on September 17 will actually happen. Futures are pricing the probability of this occurrence at roughly 20%.
What will the FOMC do? What should it do? And what are the implications for multi asset portfolios? We maintain our view that a September lift-off is possible, preferable – and not improbable. We expect to see near-term manifestations of this policy shift – and the very high likelihood of a rate hike later in 2015, if not September – at the short end of the yield curve, in the dollar and across global equity markets.
The most immediate effect of a rate hike on markets will be to disprove the naysayers who are betting on a 2016 lift-off, or beyond, generating a small leg up at the two year point of the yield curve and an incremental boost to the dollar. Markets have already been flirting with this idea, as evidenced by the tremendous rally in the dollar since late 2014 and the two-year US Treasury note at recovery highs above 70 basis points (bps). The knee-jerk reaction of developed market (DM) equities will be negative, but given the fairly solid growth picture in the US and developed markets more generally, our tactical view on DM equities remains positive. In any event, DM equities are likely to outperform EM equities as interest rate normalization unfolds.
The US economy is on a solid footing
Our view that a rate hike is imminent this year is first informed by the state of the US economy. Notwithstanding two very weak first quarters and the remaining vestiges of the financial crisis aftermath – notably tight credit conditions, sluggish aggregate business investment, flagging productivity and a housing market that has moved incrementally – US GDP has managed to generate an above-trend average growth rate of 2.6% over the past two years. At present, bright spots abound. The labour market has been tightening at a rapid clip, with the unemployment rate of 5.1% now equal to the FOMC’s own median estimate of the ”natural rate.” The number of job openings in July printed at a record high of 3.9% of total US employment, indicating strong demand for labour. All of this good news for household income reinforces a wide range of supportive indicators for consumption spending. The mighty US consumer is hitting her stride, as evidenced by blowout auto sales in July and August, as well as increases in revolving credit usage. Other measures of domestic demand, such as services
Purchasing Managers Indexes (PMIs) and housing market indicators have been broadly positive. All in all, we view the trajectory of the US economy, and the labour market in particular, as being broadly consistent with the FOMC’s preconditions for a lift-off of the policy rate. Above-trend growth has been whittling away slack in the economy, which should inspire confidence that inflationary pressures are slowly building.
A Fed move would not be a ‘shock’
It is also important to recognize that the FOMC has been communicating its intention to raise interest rates in 2015 for a very long time. So long, in fact, that one could argue it is a cornerstone of the Committee’s forward guidance. Since September 2012, a majority of FOMC participants has forecast that the policy rate will begin to rise in 2015. While this forecast does not argue for a September lift-off per se, it indicates that a policy shift anywhere in the vicinity is part of a broader and longstanding narrative.
Recent FOMC communication has been even more explicit about the prospect of an imminent rate hike, with vice chair Stanley Fischer commenting in August that it was too early to discount September even in the wake of a large dose of emerging market turbulence. Looking at market behaviour this year, the idea of a September rate hike does not appear to be shocking. Insofar as the strong dollar rally since the beginning of 2015 and the recent volatility in equity and FX are underpinned by the prospect of Fed action, the move itself is at least partially priced in. As such, validating those expectations by beginning to gradually raise interest rates might garner only a moderate incremental market reaction; a surprise for some, to be sure, but not a shock.
The risks to emerging markets of an imminent rate hike are often cited as a reason to delay – notably advocated by the World Bank and IMF in separate public communications. However, setting aside the argument that the FOMC is not a global central bank and hence need not take those vulnerabilities into account, the uncertainty generated by weak emerging market growth and fears of a China “hard landing” are unlikely to be resolved by December or even by next year. As such, by that logic the persistence of emerging market growth problems presents something of a blind alley for near term US policy.
Finally, we note that the communication of a September delay vs. a September rate hike would be a much more nuanced exercise. The FOMC is already familiar with the idea of trading off between hawkish policy action and dovish communication. A case in point is the beginning of the taper in December 2013, when the FOMC managed expectations (and blunted market reaction) by drawing down projections of the future path of rates. Similarly, a September lift-off would likely be accompanied by assurances that the pace of normalization will be very gradual.
In the generally well-understood trade-off between earlier and later initial rate hikes, moving earlier and adopting a shallower trajectory for interest rate hikes seems less risky than the task of explaining why the Committee remains in a holding pattern. If anything, the risk of sending a negative signal about the state of the economy, which would accompany a delay, is likely greater than the benefit of waiting three months for additional corroborating data.
Asset class implications
In our Multi-Asset Solutions portfolios, the implications of a Fed rate hike this year manifest themselves in several respects. For one, it contributes to a sense of cautious optimism about US equities. Although the underlying impulse for Fed action is a growing US economy, we are also cognizant of a knee-jerk reaction in equity valuations at the pivot point. In any event, such a reaction is likely to be more pronounced for emerging markets, strengthening our preference for developed market over emerging market equities.
The downside event risk in equities emanating from a rate hike or China growth fears, and the fact that correlations between stocks and bonds have been on the rise, have led us to seek diversification benefits amongst our multi asset opportunity set. In that regard, high yield credit steps into the breach. Relatively attractive valuations and the tendency of high yield credit to outperform equities in low-growth states of the economy provide a useful hedge for our exposure to US equity. Finally, we see direct implications for the short end of the yield curve, albeit moderate ones given recent moves in the two-year yield. As the FOMC kicks into gear, whether in September or December, it will provide additional impetus for short rates and some support for the dollar.
Benjamin Mandel is a global strategist, Multi-Asset Solutions, at JP Morgan Asset Management