Download When US rates rise

This is for investment professionals only and should not be relied upon by private investors
DECEMBER 2015
When US rates rise...
For some time the dominant concern affecting US and global financial
markets has been the outlook for US interest rates. In this perspective
we look at current market expectations and examine whether investor
concerns about the possible impact of rate rises are justified.
AT A GLANCE
 Investors have been concerned for
some time about the impact of a rise
in US policy interest rates.
 After many false dawns, a number of
factors suggest this time is for real
and the Fed will finally hike in
December.
 Rate rises are only being considered
because the US economy is judged to
be in a sustained recovery.
 Crucially, very low inflation and the
risk of policy error should ensure a
very gradualist approach to rate rises.
 The ‘savings glut’ and weak
investment demand arguments still
provide a rationale for structurally low
interest rates.
 Credit spreads are now much wider
than they were at the beginning of
previous rate hiking cycles, providing
an extra cushion for investors against
volatility.
 While volatility typically picks up in the
near term, in each of the last four rate
tightening cycles, US equities were
higher one year later.
 With the uncertainty reduction that it
also promises, the first rate rise from
historic lows appears quite unlikely to
derail the bull market in US stocks.
We make the case that rather than ‘lifting-off’, interest rates are likely to
‘crawl’ higher to a relative low peak level, limiting potential downside
risks for fixed income markets. At the same time, removal of a major
source of uncertainty could actually support at least a near-term
continuation of the US equity bull market.
RATE EXPECTATIONS - WHY THIS TIME IS FOR REAL
Investment commentators have been earnestly debating the likely timing of the first US
policy rate hike from virtually zero for several years now. However, each time an
increase has appeared imminent, expectations have been dashed owing to either
weak data or events, such as the recent China-related market volatility. A number of
factors suggest that this time could be different and that the US Federal Reserve will
finally increase the Federal Funds Target Rate (FFTR), probably in its December 2015
meeting or very soon thereafter. In particular, the factors supporting this view are:
Robust employment data - the US unemployment rate dropped to 5.0% in November
- the lowest since early 2008 - and is now towards the low end of most estimates of the
‘non-inflation accelerating’ level of unemployment.
Incipient wage growth - a hallmark of the post-crisis economic recovery has been
very low inflation and minimal wage growth, but recently wages have picked up. After a
strong reading of 2.5% y/y in October 2015, average hourly earnings rose a further
0.2% during the month of November, which translated into a 2.3% y/y increase.
Fedspeak – recent comments from Federal Reserve voting members and the Fed
Chair Janet Yellen particularly have pointed to a rate hike being highly imminent, with
the minutes of the last October 2015 Fed meeting showing that ‘most participants’ felt
rate rise conditions ‘could well be met by the time of the next meeting’.
Market expectations - history shows that the Federal Reserve seeks to avoid
surprising markets, typically only raising rates when there is at least a 70% market
implied probability of this. Following the strong October employment report, market
expectations for a December hike surged and crossed the 70% level.
Chart 1. US monthly non-farm payrolls and unemployment rate
350
5.8
5.7%
300
298
266
260
250
223
201
211
187
5.4
200
153
150
5.2
145
119
%
Thousands
5.6
245
5.0
100
5.0%
4.8
50
0
4.6
Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15
monthy payroll additions (LHS)
Source: Datastream, US Bureau of Labour Statistics, December 2015
Unemployment rate (%) (RHS)
WHY HIGHER RATES MATTER FOR EQUITY INVESTORS?
The outlook for interest rates matters for US equity investors for a variety of reasons.
Higher policy rates translate into higher bond yields and higher borrowing costs,
implying a less favourable credit environment. From an equity valuation perspective,
higher policy rates and Treasury yields tend to imply both a higher ‘risk-free rate’ and a
higher discount rate applied to future cash flows - other things being equal, these imply
lower valuation multiples.
In addition, there is always the risk of policy error, where it later transpires the central
bank has pressed on the brakes too early. This was notably the case in 1936, for
example, when the Fed raised rates prematurely, contributing to a collapse in asset
prices, and a policy U-turn in 1937-38.
BUT ARE CONCERNS JUSTIFIED? THE CASE FOR A SMOOTH TRANSITION
While investor concerns regarding the outlook for US rates are understandable, a number
of factors suggest that fears may be exaggerated.
Financial conditions have already been tightening - As depicted in Chart 2 below, US
financial conditions have already been tightening for the past 18 months. This has been
mainly on account of the strengthening US dollar but also because of some widening in
credit spreads. This is relevant because financial conditions typically tighten when US
rates rise. However, it is clear that despite the tightening of financial conditions to date,
there has been no discernible adverse impact on US equity performance with the S&P 500
index up by 11% since May 2014.
“A US interest rate rise is likely
before year end, but it’s hard to
see anything but a slow and
steady approach to
“normalisation”. If markets are
right, this would be the most
gradual tightening cycle ever
seen in the inflation targeting
era.”
Andrew Wells,
CIO Fixed Income
Chart 2. US financial conditions
tighter conditions
since mid-2014
2.5
Financial conditions index
2.0
1.5
1.0
0.5
0.0
-0.5
-1.0
-1.5
-2.0
-2.5
2010
2011
2012
2013
2014
2015
2016
Source: Gerard Minack, November 2015; * note higher numbers indicate tighter financial conditions and vice versa
Rate rises will be gradual - In the past three decades, US rate hiking cycles have
typically occurred in times of unequivocally rising inflationary pressures and robust global
economic growth. However, although signs of US wage growth have been emerging
recently, overall inflation is still very low (essentially fluctuating around zero since the start
2015) while the global economy is far from robust, with less than half of the world’s largest
40 economies seeing rising leading indicators in the past 6 months. This strongly suggests
that the pace of US monetary tightening will be more gradual than usually is the case.
Indeed Federal Reserve Vice Chair Stanley Fischer recently opined that the pace of rate
hikes will probably be more akin to a ‘crawl’ than a ‘lift-off’.
Further adding to a likely preference for caution and gradualism will be the experiences of
1994, when the Fed was widely perceived to have raised rates too quickly with harmful
results, and 1936, when it transpired it should not have raised rates at all.
Rates will probably peak at a relatively low level - From the long-term equity investor
perspective, what matters more than the precise timing of the first US policy rate increase
is not just the speed with which rates will rise but where they will finally settle at the end of
the tightening cycle. In this regard, it is notable that Fed members’ own estimates for the
long-run (i.e. beyond 2018) steady rate, or ‘terminal rate’, have been coming down steadily
from the median expectation of 4% in 2014 to 3.25% in the most recent Fed ‘dot-plot’
projections, with only modest expected tightening of 100bps in both 2016 and 2017.
Market expectations for the pace of Fed tightening are even lower.
“Income-seeking investors will
clearly be concerned about
the potential for the Federal
Reserve to begin tightening
monetary policy and I would
expect some volatility in
markets around rate rises.
However, such rises are likely
to be slow and gradual.”
Eugene Philalithis,
Portfolio Manager
In addition to this, there is also the pattern of the last 45 years to consider as depicted in
Chart 4. This shows that policy rate trough periods have been becoming longer and ratehiking episodes have been concluded at successively lower peak levels in real terms.
Chart 3. Successively lower peaks for the real Fed Fund Rate
10
Real Federal Funds Rate
8
Federal Funds Rate minus 5-yr
average headline CPI (blue line)
6
%
4
2
0
-2
28M
39M
93M
-4
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Source: Federal Reserve, BLS, NBER, Minack Advisors. November 2015
Structural downforces on rates - Aside from the trend of past rate rising cycles and the
Fed’s own and market expectations alluded to above, some important structural arguments
can also be made for US interest rates staying generally low compared to history.
In particular, there is a growing body of evidence that suggests that global savings are
1
structurally high owing to factors such as ageing populations and China’s structural
current account surpluses, which in economic terms are the equivalent of excess domestic
saving. On the other hand, global investment demand is also structurally low, due to
factors such as the declining relative price of investment goods and today’s companies
becoming less capital intensive, as depicted below. With high saving and low investment,
the logical conclusion is that interest rates which we know equilibrate savings supply and
investment demand, must also be structurally low.
Secular stagnation, the saving glut and low interest rates
Source: Fidelity International, December 2015
Past evidence - While the usual caveats about the past not necessarily resembling the
future should always be borne in mind, the historical evidence makes perhaps the most
persuasive case of all:
“The Fed has so far been
appropriately pragmatic in its
decision making, and has tried
to manage market
participants’ expectations as
carefully as possible. A widely
anticipated rate hike has been
well flagged, and therefore
shouldn’t come as a shock to
the market.”
Angel Agudo,
Portfolio Manager



In the one year leading up to the first rate hike, US equities have risen
appreciably on each of the last four occasions, with an average rise of 17%.
In the period soon after the first rate hike, volatility typically spikes and short term
corrections are possible.
As Chart 4 shows, in the one year after the first rate hike, returns were also
positive in all of the last four instances with an average rise of 6.8% in these
periods.
The most likely explanation for the frequently good performance of equities in both the one
year leading up to and the one year following the first US rate hike is solid economic
growth. Indeed, in terms of the last four rate hike episodes, it is worth noting that quarterly
US real GDP growth averaged 4.3% one year ahead of the rate hikes and 4.2% one year
2
after the first US rate hike.
Chart 4. One-year S&P 500 performance after first US rate rise
30th June 1999
1800
12
30th June 2004
1600
10
+6.0%
+4.4%
4th Feb
1994
1200
8
1000
800
11th Feb
1988
6
+2.4%
600
400
4
+14.3%
2
200
0
0
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
S&P 500 Composite
Post-Hike Annual Return
Fed Funds Target Rate
Source: Fidelity International, December 2015
CONCLUSION
After an unprecedented period of virtually zero interest rates, investors are understandably
anxious about the possible negative equity market impact of rising US policy rates.
However, it is worth remembering that rate rises are on the horizon only because the US
economic recovery is judged to be sufficiently robust. In addition, what matters more from
the real economy and long term investor perspective is not the precise date of the first
small rate hike from a historically low base, but the likely trajectory and end-point of rates.
In this respect, with US inflation very low, global growth still lacklustre and the risk of a
1994-style policy error a real concern, all the signs suggest the Fed will adopt a very
gradualist approach to rate rises, more akin to ‘crawl’ rather than a ‘lift-off’ along with a
significantly lower terminal rate compared to past cycles. Based on the Fed’s own latest
projections, the Federal Funds Rate will not reach the 2.0% level until 2017. In addition,
the influential savings-glut/weak investment demand arguments provide a persuasive
rationale for structurally low real and nominal interest rates.
Finally, whenever rates do rise, past experience shows that US equities tend often to rise
significantly ahead of the first rate rise – and although volatility picks up soon after the first
hike – the US stock market was materially higher one year after the first rate hike in each
of the last four hiking episodes. With the easing of uncertainty that a rate rise may also
bring, the case for the US equity bull market not being derailed imminently appears good.
“US consumption will easily be able to weather the expected modest interest
rate increases and the domestic economy may well turn out to post a
surprisingly strong performance.”
Dominic Rossi, CIO Equities
Fed Funds Target Rate
S&P 500 Index level
1400
REFERENCES
1. ‘The global savings glut and the US current account deficit’, Ben Bernanke, March 2005
2. Real GDP growth figures quoted are averages of annualised quarterly rates. The one-year ahead average figure
includes the quarter in which the first rate hike took place. The one-year post figure refers to the four quarters following
the quarter in which the first rate hike took place.
This information is for Investment Professionals only and should not be relied
upon by private investors.
This document is provided for information purposes only and is intended only for the person or entity to
which it is sent. It must not be reproduced or circulated to any other party without prior permission of
Fidelity.
This document does not constitute a distribution, an offer or solicitation to engage the investment
management services of Fidelity, or an offer to buy or sell or the solicitation of any offer to buy or sell
any securities in any jurisdiction or country where such distribution or offer is not authorised or would be
contrary to local laws or regulations. Fidelity makes no representations that the contents are appropriate
for use in all locations or that the transactions or services discussed are available or appropriate for sale
or use in all jurisdictions or countries or by all investors or counterparties.
This communication is not directed at, and must not be acted on by persons inside the United States
and is otherwise only directed at persons residing in jurisdictions where the relevant funds are
authorised for distribution or where no such authorisation is required. Fidelity is not authorised to
manage or distribute investment funds or products in, or to provide investment management or advisory
services to persons resident in, mainland China. All persons and entities accessing the information do
so on their own initiative and are responsible for compliance with applicable local laws and regulations
and should consult their professional advisers.
Reference in this document to specific securities should not be interpreted as a recommendation to buy
or sell these securities, but is included for the purposes of illustration only. Investors should also note
that the views expressed may no longer be current and may have already been acted upon by Fidelity.
The research and analysis used in this documentation is gathered by Fidelity for its use as an
investment manager and may have already been acted upon for its own purposes. This material was
created by Fidelity International.
Past performance is not a reliable indicator of future results.
This document may contain materials from third-parties which are supplied by companies that are not
affiliated with any Fidelity entity (Third-Party Content). Fidelity has not been involved in the preparation,
adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve
such content.
Fidelity International refers to the group of companies which form the global investment management
organization that provides products and services in designated jurisdictions outside of North America
Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited.
Fidelity only offers information on products and services and does not provide investment advice based
on individual circumstances.
Issued in Europe: Issued by FIL Investments International (FCA registered number 122170) a firm
authorised and regulated by the Financial Conduct Authority, FIL (Luxembourg) S.A., authorised and
supervised by the CSSF (Commission de Surveillance du Secteur Financier) and FIL Investment
Switzerland AG, authorised and supervised by the Swiss Financial Market Supervisory Authority
FINMA. For German wholesale clients issued by FIL Investment Services GmbH, Kastanienhöhe 1,
61476 Kronberg im Taunus. For German institutional clients issued by FIL Investments International –
Niederlassung Frankfurt on behalf of FIL Pension Management, Oakhill House, 130 Tonbridge Road,
Hildenborough, Tonbridge, Kent TN11 9DZ.
In Hong Kong, this document is issued by FIL Investment Management (Hong Kong) Limited and it has
not been reviewed by the Securities and Future Commission. FIL Investment Management (Singapore)
Limited (Co. Reg. No: 199006300E) is the legal representative of Fidelity International in Singapore. FIL
Asset Management (Korea) Limited is the legal representative of Fidelity International in Korea. In
Taiwan, Independently operated by FIL Securities (Taiwan ) Limited 15F, 207 Tun Hwa South Road,
Section 2, Taipei 106, Taiwan, R.O.C. Customer Service Number: 0800-00-9911#2
IC15-159