EquitiesJan 16 2020

What interest rates mean for US markets

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What interest rates mean for US markets

Just over a year ago the Federal Reserve was carrying out a series of interest rate hikes.

That quickly changed early last year, when it started loosening policy again.

This article will investigate the implications of this shift for advisers.

Central bankers’ declarations are often as influential as their actions, if not more.

Mario Draghi famously helped stabilise a dire situation in Europe when, in the midst of the region’s 2012 debt crisis, he promised to do “whatever it takes” to preserve its shared currency.

Federal Reserve

Federal Reserve chairman Jerome Powell has learned a similar lesson about the power of words, to his cost.

In October 2018, as the Fed moved to a path of rising rates, Mr Powell declared that monetary policy was “far from neutral” – a statement some took to suggest that much more aggressive, or sustained, monetary tightening was on the way.

 We do not rule out further rate cuts from the Bank of England following Brexit and from the Fed, should the US economy falter Lyxor

Though not the only suspected cause of the volatility, his words and actions have been linked by some to the fourth quarter sell-off that shook markets: all equity indices suffered severe falls in the final months of the year.

Come the end of 2019, and Mr Powell has been striking a much more conciliatory tone over the past year.

Amid challenges such as slowing global growth the Fed has in fact been cutting rates in 2019, with Mr Powell also softening his rhetoric about the path of rates.

Current conditions point to more of the same in 2020.

Though relations have improved lately, the ups and downs of the US/China trade war could create ripples of uncertainty for the world’s largest economy.

The lukewarm state of US and global economic growth will also most likely make the Fed unenthusiastic about raising rates, as will the political climate: election years are generally not a good time to be tightening monetary policy.

If anything, the Fed could ease monetary policy further if problems arise in the economy.

In a recent outlook paper the cross-asset research team at Lyxor noted: “We anticipate that major central banks in developed markets will maintain extremely loose monetary policy conditions to spur economic growth.

“We do not expect much additional easing though we do not rule out further rate cuts from the Bank of England following Brexit and from the Fed, should the US economy falter.”

Atlantic House Fund Management head of equities Fahad Hassan goes further, suggesting that US rate cuts look likely.

“With an economy close to full employment, the US government is running a deficit and Trump is putting pressure on the Fed to cut rates further,” he says.

Impact on US equities

2019, the year that saw the Fed revert back to looser monetary policy, was extremely lucrative for US equities, with the S&P 500 racking up gains of more than 20 per cent in sterling terms.

It seems unrealistic to assume that the market will perform that strongly again: one element of these strong returns was simply the fact that shares were rebounding from the fierce sell-off of 2018.

But another year of loose monetary policy should make it more likely that US equities are supported, and continue to rise in price.

Other factors should be taken into account.

As discussed, the trade war remains unpredictable and could quickly escalate.

There are also some concerns that US consumption – a large element of the economy - will falter. This could have a knock-on effect for equities.

Lyxor’s team, for one, believes that consumption should hold up, noting that “though wage inflation may not accelerate much above the current 3.5 per cent level, households should continue to enjoy solid labour income growth, which is a pillar of consumption growth alongside consumer confidence”.

For intermediaries and their clients, this could equate to a regime where US equities simply continue to rise.

But the fact that loose monetary policy has helped stocks make such large gains means some winning sectors may simply appear too expensive to warrant much exposure.

Lyxor’s analysts warn that utilities are “richly valued” and near record high prices.

Because they often act as bond proxies, or reliable stocks that yield more than fixed income, utilities could also struggle if bond yields rise, making them look less attractive to investors.

Consumer discretionary stocks are also viewed as expensive, while areas such as consumer staples have been identified as more attractive on price.

One other implication of US monetary policy for clients and their portfolios relates to currencies.

The US dollar

The US dollar, for various reasons, has remained strong versus other currencies in recent years.

This has several knock-on effects.

In the UK, where sterling has already been weakened due to Brexit-induced uncertainty, the dividends and earnings received from America are flattered by the exchange rate.

This can bolster returns for some UK equity income funds, for example.

A weaker dollar – and strengthening sterling – could remove that advantage but bolster gains from domestic exposure, meaning UK equities are one area that may have more room for good returns than the US market currently does.

A similar dynamic applies for emerging markets.

A strong dollar can hurt emerging market economies for various reasons: if the debt emerging market companies and governments hold is in dollars, this can increase their burden, for example.

By contrast, if looser monetary policy weakens the dollar this could be a boost to emerging market equities and debt – something intermediaries should bear in mind for portfolios.

As such, monetary policy should mean the chances are greater for a steady year in US equities and the funds that invest here.

But with potential positive knock-on effects for other parts of the investment universe, clients may wish to look elsewhere for standout returns in 2020.