The U.S. economy has come a long way since the depths of the financial crisis. The unemployment rate was cut in half, from 10 percent in October 2009 to 5 percent in October 2015. The housing market has turned from a source of vulnerability to a source of strength, and low energy prices and cheaper imports are supporting increases in consumer spending.
The road to recovery has been slow, but after seven years of ultra-accommodative monetary policy, the Federal Reserve finally appears ready to raise interest rates off of zero.
This is important for the economy and investors alike—not only because an increase in rates will mark a major shift in U.S. monetary policy, but also because it is likely to occur just after the European Central Bank (ECB) extended its quantitative easing stimulus program and reduced interest rates to negative 0.3 percent. The policy divergence among central banks is likely to remain a key factor driving the risks and rewards for global investors into 2016.
Rate Hikes Beyond December: Why, When, and How Much?
Despite a seeming cacophony of different voices and views coming out of the Federal Reserve in recent months, the communication has been fairly clear: The Fed leadership sees a U.S. labor market that is nearing full employment and inflation that is low but expected to move higher. The bottom line is that the Fed increasingly seems to feel the economy is strong enough to warrant, and to weather, an initial increase in the federal funds rate.
We expect the Fed to raise rates in mid-December. And financial markets are already reflecting these odds, dampening the likelihood of another “taper tantrum” on the announcement. With good reason, the timing of this first rate hike is front and center in most portfolio discussions.
However, the second rate hike is arguably much more important for the market outlook because of what it reveals about the entire glide path of U.S. interest rates. The Fed has stated that it intends to move “gradually,” but what that means is open to interpretation. In the view of Russell Investments, a gradual approach will probably entail an increase at every other meeting, for a total of 1 percentage point per year. Underlying this view is a belief that as the U.S. unemployment rate falls toward 4.5 percent in 2016, the tighter labor market and upward pressure on wages will eventually feed into broader measures of inflation.
This would represent the slowest rate-hike profile in the modern history of U.S. monetary policy. (See Figure 1, below.) Yet the overnight index swaps (OIS) market expects the Fed to move even more slowly. Prices currently reflect only two 25 basis-point rate hikes per year. This means that if Russell Investments’ monetary policy outlook is realized, then long-term interest rates will likely move higher than expected, with the 10-year U.S. Treasury yield increasing to roughly 2.8 percent over the next 12 months.
U.S. inflation will be a key watch point for fixed income managers in 2016. A stronger dollar and lower commodity prices have exerted significant downward pressure on consumer prices this year. The speed and extent to which these forces dissipate will be important to the Fed as it considers how quickly, and how much, to continue hiking rates over the course of 2016.
What to Expect as U.S. Interest Rates Rise
The transition from absolute certainty on the path of Fed policy (i.e., forward guidance) to what is now a data-dependent and inherently less certain future for U.S. interest rates means that we can expect more frequent bouts of volatility in financial markets going forward. Recent years of very low volatility were the exception, not the norm.
On the plus side, the risk of a global recession appears low in 2016. The fundamentals of the U.S. economy are sound: The labor market is back to normal, but not overheating; household balance sheets are stronger than they were in the mid-2000s; and business investment remains well below the worrying levels seen in the late 1990s.
The corporate credit cycle does show signs of maturing. But in the absence of clear economic imbalances, we think the recent experience of modest, positive growth can continue in developed markets. Combined with heightened volatility in financial markets, this should provide nimble investors with greater opportunity to lean into (and out of) swings in investor sentiment.
The role of cash: Today and tomorrow. Even in an environment of negative real interest rates, cash has value. It allows investors to capitalize on dislocations caused by market volatility. And after years of strong market performance, the expected returns on most risky assets have moderated. This means that the spread or opportunity cost of holding cash is much lower today than it has been in some time. As U.S. interest rates start to rise, cash will become incrementally more attractive and will play an important role in portfolio risk management.
Where are equities headed? The developed-market economies have largely proven resilient to concerns emanating from China and the emerging world. In the United States, we have witnessed a significant broadening of economic growth in recent years. From 2010 to 2013, rate-sensitive sectors of the U.S. economy contributed roughly 60 percent1 of all private-sector growth. That number has fallen below 40 percent today, making the economy far less vulnerable to the tightening monetary policy. The manufacturing sector does face challenges. But on net, we expect real gross domestic product (GDP) in the United States to grow by 2.0 percent to 2.5 percent in 2016.
Nevertheless, it is hard to get overly optimistic about U.S. equity markets. Rising interest rates have historically been a headwind for valuation multiples. And valuations are already elevated, particularly after U.S. stock markets’ strong performance in the month of October. But in the aggregate, we see greater opportunity in other regional markets.
Eurozone equity markets are toward the top of Russell Investments’ list in terms of where the firm sees the greatest confluence of market tailwinds today. The European economy is improving; earnings growth remains strong; the exchange rate is favorable; valuations are attractive relative to the U.S. market; and Europe should be relatively insulated from higher U.S. interest rates, as ECB president Mario Draghi considers launching an even more aggressive monetary stimulus program this month. Investors have done well the past few years when they’ve followed the global central bank printing press, and we expect ECB stimulus to be a key tailwind for a market that is also supported by strong fundamentals.
1. Source: Russell Investments. This statistical model uses U.S. Bureau of Economic Analysis data that identifies rate sensitive sectors in the economy and then calculates their contribution to growth.
One of the biggest wild cards in 2016 is what changes in monetary policy will mean for emerging markets. Theoretically, higher U.S. interest rates hinder emerging-market growth, as they entice capital outflows away from the developing world. And these nations’ economic cycle remains challenged as the slowdown in the Chinese economy ripples across its trading partners in Asia and commodity producers around the world.
However, emerging-market valuations are currently cheap. Resolution of U.S. interest rate policy and a bottoming out of the business cycle could serve as catalysts for a turnaround next year. For more tactical investors, we think a cautious approach is warranted until there is greater clarity on interest rates and growth in emerging markets.
What about fixed-income and currency markets? As U.S. policy diverges from that of other major central banks, the U.S. dollar is likely to face further upward pressure. Given the significant appreciation already seen over the past year, however, expensive valuations suggest that further upside in the dollar is likely to be more modest. Nevertheless, in a world of divergent central bank policies, investment managers still need to think carefully about how currency spreads may affect their global investment performance and which strategies may provide protection against currency risk.
From a fixed-income perspective, higher U.S. rates in 2016 support a cautious stance toward duration exposure in U.S. Treasuries. However, corporate high-yield debt, including in Europe, offers a fairly attractive spread. Default rates should remain contained in an environment where the risks of recession remain subdued.
The Bottom Line
The bottom line is that there are likely to be winners and losers in this new world of higher U.S. interest rates. In such an environment, we believe globally diversified, tactical multi-asset investment strategies are well-suited to help manage these new risks and capitalize on new opportunities as they present themselves. Investors need access to outperforming managers in every sector and the ability to enhance returns by opportunistically adding exposure to nontraditional securities. In short, investors need to continue paying attention to every detail about their portfolio management. In a low-return world, every basis point counts.
Paul Eitelman serves as an investment strategist at Russell Investments, where his research and views help guide the firm’s multi-asset portfolios and services for institutional and retail investors. Prior to joining Russell in March of 2015, Eitelman served as vice president and senior economist at J.P. Morgan Private Bank in New York. He previously worked at the Federal Reserve Board, where he was the lead economic analyst for several emerging-market economies in Latin America and Southeast Asia.
NOTE: The views expressed in this article are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.
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