Are Equity Markets Complacent And What Can Past Fed Rate Rise Cycles Tell Us About The Future? Mark Burgess, ColumbiaManagement
- We are still positive on equities versus other assets, particularly core bonds, although the list of potential headaches for equities is not insignificant and appears to be growing.
- Japan’s recent progress on the corporate front is a cause for optimism. Equities are about the future and the outlook for corporate Japan is better than it has been for some time.
- While equity market beta has served investors well in recent years, the broader valuation re-rating of equities and levels of forecast earnings growth would suggest that the easy money has been made.
Developed world stock market indices such as the S&P 500 and FTSE 100 have recently reached a series of record highs. At the time of writing, Japan’s Nikkei has just reached a 15-year high. This will make investors wonder whether equities have become a little complacent, given the geopolitical concerns that Colin Moore mentioned in his leader article.
From our own perspective, we are still positive on equities versus other assets, particularly core bonds, although the list of potential headaches for equities is not insignificant (and appears to be growing). Without wishing to plagiarize Donald Rumsfeld, the current list of ‘known unknowns’ for equity investors includes:
- The impact of the growth slowdown in China.
- The strength of the dollar – how much of a challenge will this turn out to be for U.S. multinationals?
- Geopolitical risks in Russia, the Middle East and elsewhere.
- Will ‘Abenomics’ work?
- Oil prices – will they remain at or near current levels, or will production cuts mean higher prices in the second half of this year?
- What is the long-term impact of the current malaise for emerging market commodity producers?
- Greece – will it exit the single currency, and what impact would that have on the euro?
- The timing and extent of U.S. interest rate rises.
The latter issue is probably the $64,000 question for many investors, with one market participant likening the Federal Reserve’s recent policy signaling to Michael Jackson’s moonwalk. This is probably not an approach that fills investors with confidence. What we can say for certain is that the Fed is likely to raise rates this year. It is therefore worth considering what a rate rise might mean for equities, particularly as the Fed has removed its commitment to remaining ‘patient’ on the policy front.
With the U.S. as an example, data from the post-war period gives us some insight on the impact of Fed tightening cycles. The table below shows the impact on equities of the last 12 tightening cycles:
Exhibit 1: Impact of Fed tightening (using the U.S. stock market as a proxy)
Sources: FactSet, Barclays. Data based on the 12 hiking cycles since the early 1950s, index used is S&P 500 price index in dollar terms.
Returns tend to be strong in the three months before the first rate hike, with positive returns observed on 11 out of 12 occasions. However, equities tend to make progress six months and 12 months after the hike, and even in the three months immediately after the hike, returns are positive half of the time.
The data would seem to suggest that equities should not have to worry too much about the Fed tightening cycle if the past is any guide. There is an important caveat here though. In previous tightening cycles, the Fed has tended to raise rates because of strong economic growth, and that has usually coincided with periods of robust earnings growth. Put another way, while higher interest rates may lead to valuation compression, it hasn’t mattered that much for the stock market because earnings have risen appreciably, leading to further increases in stock prices. This time round, U.S. earnings growth is expected to be in the very low single digits, and this comes in an environment where almost every major world currency has weakened against the dollar, making life tough for U.S. multinationals.
This might sound bearish for equities, but it should not be interpreted that way. Our portfolio managers continue to find a range of stock-level opportunities across global markets, including the U.S. One way to manage the impact of a stronger dollar is to look at U.S. companies with primarily domestic revenues, such as those in the small or midcap areas, or among large caps where concerns over earnings growth or currency have become over discounted, thus presenting potential for a longer term valuation re-rating once those fears dissolve. By definition though, this means that investors have to be willing and able to pick and choose, and we think that is very important given where valuations are now and the low projected rates of earnings growth. Equity market beta has served investors well in recent years. However, the broader valuation re-rating of equities and levels of forecast earnings growth in markets such as the U.S. and UK would suggest that the easy money has been made.
We will revisit some of our ‘known unknowns’ in future commentaries, but if there is one thing that we would highlight on the current list, it is Japan. In local currency terms, the Japanese market has made great strides this year and valuations remain undemanding, suggesting that there could be more to come from the equity market, especially if the yen remains weak versus the dollar. Japan is also a major beneficiary of lower oil prices.
There is more to Japan than that though. For years, corporate Japan has been criticized for its lack of focus on shareholders and its use of cross-shareholdings, which have been blamed by the government for sustaining a culture of complacent management and low returns. But the wheels of change are beginning to turn. One of Japan’s leading industrial companies (famous for its less-than-amiable attitude towards investors) has said that it wants to have a constructive dialogue with shareholders and will set up an investor relations team. Such a move would have been unthinkable just a few years ago, but shows that change is underway. The domestic Japanese pension funds, including the huge GPIF, are also switching on to the benefits of equities (both local and domestic), providing a further source of optimism.
Japan’s longer-term challenges are well known (the highest gross debt-to-GDP ratio in the world and a shrinking population to name but two). That is why Japan is said to be a market that investors may want to date, but not marry. Nonetheless, the recent progress on the corporate front in Japan is a cause for optimism. Equities are about the future and the outlook for corporate Japan is better than it has been for some time.