The moment of truth may soon be upon us. After a nine-year wait, by the end of the year we may be seeing the first rise in U.S. interest rates since June, 2006. We and the market believe that the latest round of U.S. employment data - together with less perceived angst in the rest of the world - will give the Fed sufficient reason to raise interest rates by 25bps in December. While it is easy to dismiss a 25 basis point increase in rates as relatively inconsequential, it may still put some fear into global markets. The fear is not so much about a 25bps rise in rates; it’s more about what may lay beyond this first increase. The way the markets deal with that fear is going to set the tone for the markets over the turn of the year.
‘Strong US jobs growth should prompt US rate rise’
The recent U.S. labour market report appears to have made a U.S. rate rise in December a done deal. The report showed that 271,000 new jobs were created last month, and that the unemployment rate fell from 5.1% to 5.0%. Significantly, average hourly earnings rose 0.4% month on month, taking the annual change up to 2.5%. The U.S. money markets now price-in a 68% probability of a 25 basis point rate rise at the FOMC meeting ending on the 16th December.
Any reservations about the real strength of the U.S. labour market data will probably have little impact on the timing of the first rate rise. Despite the strong headline employment numbers, all is not well in the U.S. labour market. October was fine for those who were 55 or older and looking for a job, but more difficult for those aged between 25 and 55. Those aged 55 and above saw job gains of 378,000, whereas workers aged 25-54 saw the number of jobs decline by 35,000. Since December, 2007, workers aged 55 and above have seen over 7.5 million jobs added, while workers aged under 55 have seen 4.6 million jobs lost. Such structural imbalances in job creation probably go some way to explaining why wage growth has been restrained; those aged 55 and above typically have limited ability to negotiate higher salaries.
The backdrop to a rate rise is becoming more supportive of one, given that various data points from the U.S. have been on the stronger side. While U.S. economic data in aggregate has remained marginally negative, the degree to which the numbers have been below expectations has substantially improved from the dark days of late September/early October. Apart from the employment data, the other stand-out positive economic news in the U.S. came out of the services sector. The ISM non-manufacturing sector index rose sharply, to 59.1, from 56.9 in September. The readings from such surveys should be interpreted with care, because they are based on human sentiment, and one should not infer a precise level of growth from any single industrial confidence survey reading. It could be that after the relative economic slackness of the summer months, recent trading has indeed been better, although we intuitively doubt whether it has been sufficient to justify a 59.1 reading on the services index.
The global financial markets may now be better placed to take a rise in U.S. rates in their stride, unlike in August/September, which saw large market falls. It is probably different this time, as U.S. economic data is more positive, and the rest of the world looks calmer after the economic weakness of the third quarter. Even if growth in a particular developed country is weak (e.g. Japan), the markets increasingly expect policy makers to provide support. The ECB is committed to further phases of significant quantitative easing, and meanwhile the Chinese authorities are busily pumping liquidity into their economy, and also providing fiscal support via increased infrastructure spending.
For the foreign exchange markets, it will not be the actual decision to increase U.S. rates in December that will be important, but rather the way the Fed signposts its intended pace and scale of rate increases thereafter. In the past it was thought that the Fed would raise rates, although signal - as Janet Yellen did just last week - that future rate rises would likely be limited in extent. However, the nature of policy statements may change. The problems the Fed has had in recent months in communicating its intentions to the market may leave them feeling it could be safer to leave forward guidance regarding further rate increases more open-ended.
‘Euro & yen pressured by a strong dollar’
We suspect that a rate rise In December is well discounted in foreign exchange markets, especially given last week’s rise in the trade-weighted U.S. dollar index to the top of its trading range. Any break-out from this range, that has held for most of the year, will be determined by the market’s perception of the likelihood of further significant increases in U.S. interest rates through 2016. Considering the euro, this has broken recent downside supports, and appears to be targeting $1.05 in the near-term. Given the ECB is seen as unlikely to raise rates until well into 2017, any sense that the Fed could raise its rates more aggressively than is currently priced-in could send the euro rather lower. The yen is probably headed to around the 125 level, last seen in August. Last week’s poor economic news from Japan might pressure its central bank to increase quantitative easing earlier than previously expected, which would lead to renewed weakness in the yen. A move in the $/Yen much above 125 would be technically significant, as it would represent a break above the trading range that has held for over 10 years.
There was a modest sell-off in U.S. Treasuries in the immediate aftermath of the employment data. Riskier bonds absorbed the bad news to some degree, as credit spreads in general narrowed. We suspect that the U.S. 10-year yield may rise still further to around the 2.40% level in the very near-term, having broken the 2.30% level and currently at 2.33%. A move much higher than 2.40% would probably need further evidence that the U.S. economy was building a head of steam and that further rate rises beyond that now expected in December were possible in the first half of 2016.
With the Fed’s likely rate increase in mind, we remain very selective buyers of equities. We believe eurozone equities can continue to outperform U.S. equities, on a currency-hedged basis. The recent weakness of the euro will have provided a significant fillip to eurozone industrial confidence, and should lead to upgrades to corporate profits forecasts, led by exporters. We continue to favour Chinese equities, preferably via exposure through the H-share index, given that market’s cheap valuation of 7.3 times next year’s earnings.
‘GCC equities already discount much bad news’
GCC equity markets could also be due a rebound, although this is a relatively risky call. GCC equities have keyed-off the still subdued oil markets of recent weeks, also reflecting the ripple effects felt across a variety of sectors, making this one of the worst performing regional equity markets. Oil, like many commodities, was weak after the payrolls data, with WTI falling 2%, and the MSCI GCC index now stands at a 10-year price relative low versus the MSCI All World equity index. Since October, GCC equity markets have underperformed global equities by 12%, and we believe they now discount much bad news. Accordingly, we are increasing our regional equity weightings from underweight to neutral. Within these markets, UAE equities are favoured, with particular regard to valuation.
The tragic events in Egypt last week will further undermine efforts by the government to reverse recent weak growth and structural imbalances in the economy. A recent modest recovery in the Egyptian tourist industry will have been stopped in its tracks. Russian tourists were the number one source of visitors to Egypt. Even before last week, tourism receipts were expected to reach only $8bn this year, compared to the peak of $11bn in 2011. With central bank foreign exchange reserves at a modest $16.4 billion at the end of October, the Egyptian pound is likely to remain under downward pressure.
Lastly, keep an eye on Iceland. The country was grappling with the global financial crisis when its whole financial system collapsed. Last week, Iceland’s central bank raised interest rates by 25bps, with further increases likely as GDP growth is vibrant and projected to be well over 4.0% this year and next. The reason for the increase in interest rates is that Icelanders paid themselves an 8.2% increase in salaries during the summer…. Now there’s a thought!SHOW MORE