After three years of relatively stable markets, volatility has ramped up in 2015 with investors periodically concerned about China and Greece and the strength of regional earnings growth. Matt Sherwood, Perpetual’s Head of Investment Strategy, Multi Asset ,examines what this means for investors.
After three years of relatively stable markets, volatility has ramped up in 2015, with investors periodically concerned about China and Greece and the strength of regional earnings growth, but these concerns have subsequently diminished after varied policy actions.
Matt concludes that this trend reflects the combination of a higher debt, lower economic growth and a massive oversupply of global liquidity from central banks. Even though Greece’s debt is likely to rise further and its economy looks perilously weak, investors seemingly want to move on from these concerns and those about China, with the US Federal Reserve and their endeavour to end a seven-year experiment of zero interest rates the next sentiment hurdle. In this world, market volatility is likely to rise further but the risks from US policy hikes are more in the emerging markets as early rate hikes will leave plenty of room for US sharemarket gains.
- Despite the recent deal, my base case is for Grexit in the next 1 to 3 years but a financial crisis and regional recession is a very low risk in this environment given the ECB’s resolute firewalls, improving bank balance sheets and who in the end holds Greek debt. However, two other risks remain: firstly, a structurally slowing China with high debt, and the US Fed who are set to end seven years of zero interest rate policy in the coming period.
- The US Fed have made no secret of their desire to take back some policy ammunition for the next downturn and some investors have taken heart from this as it will mean a better and more sustainable US recovery, which is constructive for corporate earnings. History has demonstrated that it takes large interest rate hikes to generate below-average US sharemarket returns. Over the past ten US tightening cycles dating back to 1958, Australian shares have outperformed the US on nine occasions and by an average +18% in the subsequent two years. Generally the smaller the rate rise, the better the absolute and relative performance for US shares.
Introduction – Low rates and leverage
Given their record and highly unorthodox economic policy over the past seven years, there is little doubt that the US Federal Reserve has been instrumental in saving the US and global economies from another Great Depression. Indeed, record lows rates in the US from both a cash and a bond market perspective has not sparked a major rise in overall borrowing as de-leveraging in the household sector has offset a rise in public sector debt, culminating in the US recording one of the smallest rises in leverage of the G15 economies. Indeed, the largest rises have been in Europe (six of the top ten rises) and Asia (three), with the global average debt increase being +40% of GDP, which means that the US leverage rise over the past seven years has been less than half the global average (see Chart 1).
Market gains after rate hikes
While lower US rates have not had much of an impact on the debt dynamics of their economy, highly accommodative monetary policy has had more of a financial market impact. Indeed, US policy has sparked a search for yield in risk markets, which has seen US sharemarket valuations rise to stretched levels in recent years. However, the change in US earnings has been quite similar to the growth in US share prices since mid-2007, which suggests that the recovery in sharemarket valuations since 2011 has partially reversed the excess selling in 2008/09 with valuations back to the elevated levels they were before the crisis.
US Fed guidance has been very deliberate
History never stands still and the US Fed wants investors to understand that its’ zero interest rate policy is not a permanent feature of the US financial landscape and to expect a change before too long. Chairman Yellen began this process by having investors change their focus from over-analysing the Fed’s forward guidance to examining incoming data particularly inflation and unemployment. In this way improved US data and any associated rate hike will be less of a shock to investors and give the US Fed better control over timing. The problem with waiting to see inflation above the US Fed’s 2% target is that it risks an abrupt rate rise, which could risk a 1994 repeat of losses in bond and share markets. Clearly, there is never a perfect time to hike rates, but doing it earlier will mean that there is less risk of an abrupt rise which could destabilises markets and the US economy.
The history of US Fed rate hikes
Since 1957, the US Federal Reserve has initiated a policy tightening cycle on ten occasions, with the average rise being a 4.9%. Clearly the US economy could not withstand a rate rise of that magnitude nowadays given its high debt, less favourable demographics and the weak global economy. Moreover, the rise in the US dollar over the past year has already been equivalent to three 0.25% rate hikes in terms of tightening US financial conditions. History has shown that the first few rate hikes leave plenty of room for markets to keep rising. Although US shares have rallied in only six of the past 10 tightening cycles (see Chart 2), it has to be remembered that some of these negative trends reflected black swan events such as Watergate and the first oil crisis (both in 1973/74).
CHART 1: THE POST-GFC WORLD HAS BEEN ONE OF RISING LEVERAGE AROUND THE WORLD
CHART 2: AUSTRALIAN SHARES – CONSISTENTLY OUTPERFORM AS US RATES RISE
US Fed in 2015 – Late, weak and choreographed
More importantly, investors need to stop focusing on the start of the tightening cycle as being the most important risk event in the next few years and instead should examine the pace and the nature of the rate increases themselves. Overall, the US Fed funds rate is likely to peak around 2% in late 2017, which suggests that the pace of rate hikes is likely to be very gradual and guarded because the US Fed will not risk the economic recovery to get rates to a pre-determined level by a pre-determined date. This means the US Fed is likely to be very measured in its tightening cycle as surprise deflation is a much harder enemy to defeat than surprise inflation, and this is another way the US central bank is calming market nerves. Within the US sharemarket, higher rates will be beneficial for banks and capital goods, but will be a headwind for utilities, IT and consumer staples.
Who's at risk from US Fed policy?
While I consider US equities and the US economy to have low risk of adverse reactions to modest US rate increases, global spill-overs are less certain and potentially destabilising. While history suggests that tighter US monetary policy is associated with stronger US growth, and therefore is a positive for emerging market exporters, those are global averages when global trade growth was notably higher, the US dollar was very much lower and the debt of these economies was considerably less. In this way, emerging markets who have raised a large amount of US denominated debt in the past few years and have weak domestic growth outlooks will be particularly vulnerable to lower commodity prices, higher US rates and an appreciating US dollar.
Implications to investors
Overall, there is a dangerous sense of complacency in markets with investors seemingly happy to overlook risk in the wake of policy changes in Europe, but in the end Grexit risks are delayed not resolved. Indeed, Greece’s debt to GDP ratio is likely to lift substantially primarily due to the Greek economy becoming recessed again in the wake of all the fiscal austerity required to meet their reform requirements in exchange for a bailout. In the end, Greece needs to run a primary surplus of 3.5% of GDP for three decades for debt to be sustainable, which is simply not achievable for an economy whose largest employer is government and whose precautionary savings are likely to rise. Nevertheless, investor’s faith the ECB’s firewalls remain resolute and the spillover from Athens to other periphery countries is likely to be very low.
Similarly, the US Fed is likely to have a modest effect on the US sharemarket and the US economy as long as economic conditions unfold as expected. The US economy is solid enough to withstand a modest amount of tightening, but the real risks from a higher cost of capital is going to be in the emerging markets and things here are unpredictable and likely to move fast.
The fortunate thing about this risk is that we have known about it for an extended period and I maintain my view of a 2% peak in the Fed Funds Rate, which will be reached in late 2017. Over this time, I am not expecting a large back up in Treasury yields, as US financial conditions have already tightened with the rising US dollar over the past year being equivalent to 0.75% of rate increases.
For investors who want to de-risk portfolios from the impact of higher US rates you could look at other regional sharemarkets and Japan here is a standout– it has lower valuations, continued policy support, an improving corporate sector and 31 consecutive months of improved earnings. Europe is also constructive as long as Greece has no spillover effects. In both these regions, policy is likely to remain supportive, currencies constructive and earnings growth positive. That is as good a pedigree as you can find in these highly volatile markets.