Expert comment: “The potential implications of US Federal Reserve interest rate hike”

14th December 2015

Trevor Greetham, head of multi-asset at Royal London Asset Management, comments on the potential implications of a US Federal Reserve interest rate rise…

With US stocks back to record highs, the Federal Reserve is widely expected to embark on a monetary tightening cycle for the first time since 2004.

There are some confusing messages from the world economy about what may happen after the US starts to normalise interest rates. The underlying economic cycle will help investors judge the pace and severity of tightening.

Our ‘Investment Clock’ model, which links the global business cycle to the performance of different assets, shows an indeterminate picture.

While falling unemployment rates in the major economies indicate that the period of above trend growth that began in 2009 is intact, confidence surveys relating to the global manufacturing sector are weak. Likewise, while the trend in global inflation has been downwards since China started to slow and commodity prices peaked in 2012, base effects suggest a rise in measured inflation rates heading into 2016.

We discount the idea that it will be ‘one and done’ with Fed rate hikes. Consumer strength is driving the U.S. unemployment rate lower and consumers are benefiting from the slide in energy prices. Our base case is that the Fed is a lone hiker, pushing the dollar still higher but with tightening moves gradual enough to keep stock markets on a positive trend.

We expect global growth to pick up in 2016 led by the US, a strong dollar helping to keep US inflation low and monetary policy relatively loose, to the benefit of developed stock markets. However, this scenario points to further downside for commodity prices and further stress across emerging markets.

The alternative scenario that requires the closest monitoring embodies a more inflationary and synchronised upturn with all parts of the world growing more rapidly; a move into the ‘overheat’ phase of the Investment Clock cycle. US growth should remain strong. Meanwhile, euro area growth could surprise positively with the monetary base and credit measures expanding rapidly, even before the European Central Bank increased its stimulus.

Even China could see better activity as various monetary and fiscal easing measures take effect. In this scenario we would expect to see a series of Fed rate hikes and an increase in volatility in the financial markets. Commodities and emerging markets could rebound as bond markets sell off. European equities look well placed either way.

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