Pau Morilla-Giner (pictured), Chief Investment Officer at London & Capital comments on whether the path for an interest rate rise has now been set…
When the US Federal Reserve (Fed) issued its latest statement (19.03.14), markets were less than supportive. As a result, stocks fell, the US dollar strengthened and yields rose, consistent with the market bracing for slightly higher interest rates.
What got our attention was the fact that the Federal Open Markets Committee’s (FOMC) consensus for 2015 is changing. Consensus expectations for interest rates at the end of 2015 are now 1.13%. Fed funds rate has been between zero and 0.25% since 2009. So, some suggest that to be at 1.13% by the end of 2015, the Fed would have to start raising rates sometime later this year.
Our view is that when the Fed starts raising rates it doesn’t have to do it slowly, and given how much is at stake, a rate rise in 2014 is extremely unlikely.
Interest rate normalisation leaves no place to hide for asset allocators, particularly equity players, since sovereign yield will track the US curve.
Deep value comes at a price at this stage. Emerging Market (EM) equities could suffer the most as volatility pressures mount and China’s credit bubble fears hit more headlines, yet in the end is the only place where you can find cheap opportunities. A valuation re-rating reward backs an EM long term investment case, although timing in the short term is of the essence.
If the global economy, led by the US, can begin to accelerate in the back half of 2014, then we are well set up to beat expectations going into 2015. The good news is that US households have never been wealthier (either in USD terms of adjusted by inflation).
Bringing forward the Fed’s members’ median view on future rate rises is of course highly dependent on the economy following the relatively strong recovery path that the FOMC have painted. It looks like the jobs outlook continues to be the main driving force for economic outlook and perhaps having a new Chairperson allowed the Fed hawks’ views to be properly heard and aired.
A flatter US Treasury yield curve was the natural response, and we may see some additional volatility in high quality sovereign bonds and investment grade, as markets look to establish a neutral level. This target level may be 3.0% for US 10-year Treasuries (2.8% currently).
The main difference to last May/June when many fixed income (FI) sectors suffered was that the 10-year Treasuries were then at an unsustainably low 1.6% yield. This time round the yield is 1.2% higher, and may have priced in much of the QE unwinding that is currently in motion. Also, the story back then was that of global liquidity contraction, while the FOMC story was about a gradual rise in the cost of borrowing at an adjusted pace.
The effect on EM debt may be negative as a knee-jerk response, but is unlikely to be a repeat performance of last autumn. The selective EM FI securities we favour are geographic specific, i.e. China and India, with some minerals/commodity exposure via companies such as Vendanta and First Quantum. These should be relatively immune to any rise in US Treasury bond yields, and there is a sufficient yield spread cushion to support current valuations.