Kames CIO: Why equity investors should not fear a US rate rise
Stephen Jones, Chief Investment Officer at Kames Capital, analyses the likelihood of a US rate rise next week, and explains why a move to hike rates would not spell disaster for equity investors.
“The FOMC (Federal Open Market Committee) meets next week to discuss monetary policy. After many months of hinting that they would like to finally move interest rates above emergency levels, it remains by no means obvious that they will decide to implement a tightening of policy at this meeting.
“In view of the importance of an increase in interest rates and the signal it gives, if they do act the FOMC will want to be very clear as to their motives. Why they are acting, whether they will do more and at what pace, and where they expect rates to end up over the medium term are all key questions. Secondary issues will also be raised, such as their policy towards the balance sheet of the US Federal Reserve and the SOMA (System Open Market Account) portfolio. The FOMC said previously that, at the very least, the size of this portfolio would be maintained until after interest rates were raised.
“Opinion remains mixed as to whether rates will actually rise, primarily because it is far from obvious that there is an economic case to do so. The US economy is growing steadily but not dynamically, inflation is temporarily depressed by recent falls in the oil price, core inflation is healthier but not alarming, and unemployment is falling. Meanwhile, wage growth is restrained and monetary conditions have already tightened via the stronger US Dollar, and weaker financial markets. The IMF and the World Bank have also urged the Federal Reserve not to act.
“On the other hand, the economy isn’t behaving as if emergency rates are warranted. It will therefore be a close call either way, but one that we see as backing a modest rise in interest rates, and very restrained action thereafter.
“So what will it mean for financial markets? It is likely that the volatility that has been a feature of this year will continue. This is the first tightening cycle since 2004. An awful lot has happened since then that would suggest this interest rate cycle is going to be very different from anything in the recent past, but in ways that are difficult to predict at this stage. We would expect yields on short-dated US Treasuries to rise but expect longer dated bonds to be more stable, particularly if equity and commodity markets take fright. Elsewhere, we remain a little cautious regarding investment grade credit. While a rate rise would suggest strength in the underlying credit fundamentals are good, fund flows and heavy corporate issuance remain likely to weigh on credit markets to some extent.
“What a US rate rise means for the global economy will continue to be an issue of concern, especially for emerging markets where a strengthening US Dollar will continue to act as a headwind. For the US economy however, it is hard to see how it will make an awful lot of difference. In general, financing rates – whether for mortgages or corporate loans – tend to be based on longer maturity interest rates. Market volatility could affect confidence, but conversely the removal of emergency policy rates may act to boost confidence as it would signal a return to ‘normality’.
“US equity markets have spent the summer absorbing what has been a good earnings season (outside of energy and commodity-related stocks). Whilst the rally in equity markets is well established, further progress can be made in an environment of very modest interest rate rises and continued consumer confidence, supported by increases in bank lending.”