The world is going to have to wait a little longer for the first US interest rate rise of the current economic cycle. While Chair Yellen conceded that the US economy seemed to be on an improving trajectory for the moment (there were, nonetheless, downgrades to the committee’s 2016 and 2017 growth and inflation expectations), the committee seems keen to wait for less restive markets and a less ambiguous international backdrop. Market expectations for a rate hike have now more or less shifted into next year in deference to the very dovish tone of Chair Yellen’s statement and the changes to the Fed’s forecasts.
That markets are agitated in anticipation of a US interest rate increase is perhaps understandable. One colleague rightly pointed out this week that iPhones had not even arrived on the market place the last time the Federal Reserve raised interest rates – many of our youthful forecasting community will never have seen a rate rise in their professional career. Meanwhile, the debate in both media and professional financial circles increasingly lacks nuance and important context. How influential these factors were in keeping the Federal Reserve on hold is open to debate. Somewhat perversely, however, it may be that an interest rate rise is the one thing that will help calm markets (and commentators) down a little, not the other way around.
The reaction of developed equities in the wake of the decision goes some way to supporting this idea. In theory, a more cautious Federal Reserve should be taken positively by risk assets, as much of the commentary in the run up to the decision suggested. However, the tone of the accompanying statement has served only to blur the timing of the rate rise further, thereby fuelling uncertainty and making markets yet more agitated, with the more economically sensitive parts of equity markets so far bearing the brunt of the selling pressure (though some de-risking in European equities may be attributable to another weekend of Greek elections).
How long can this potentially self-reinforcing feedback loop between the Federal Reserve and markets endure? That is obviously hard to say. Regular readers will know well that we’ve long thought the US economy is capable of digesting significantly higher interest rates. This week, we saw further evidence that the US consumer, customer number one for global plc, is in fine shape. Inflation admittedly remains subdued, but our feeling is that the dampening effects of last year’s oil price declines are on the way out of the data. Domestic factors, such as wages, may soon show up more forcefully. The same goes for the UK economy incidentally, where this week’s employment data showed wages picking up at a fairly brisk pace amidst diminishing labour supply.
China and the emerging markets
We continue to believe that those worrying about China’s effect on the US may be getting cause and effect the wrong way around. As the world’s largest consumer economy and net importer, the US economy remains the key driver behind global demand. The US economy should remain well insulated from external factors relative to some of its developed peers. As we pointed out in In Focus – The implications of low oil prices, 11th September
, it may well be that the proceeds of last year’s dramatic declines in oil prices are about to show up more visibly in the consumption and output statistics of the net oil importers of this world. Furthermore, US import growth is historically pro-cyclical, meaning that continued growth in the US should partially offset weak demand from China, likely helping to paper over some of the economic cracks currently appearing in emerging markets.
These factors, in combination with the recent pick-up in Chinese fiscal spending and a firmer tone to the Chinese housing market, may help settle market nerves a little. A dithering Federal Reserve may well continue to have the opposite effect. Diversification across asset classes and geographies remains important, but we still see portfolios being well served by having a strong strategic and tactical leaning towards equity markets.