Neil Williams, Group Chief Economist:
Today’s US Fed rate hike, to 0.75%, was so well telegraphed it should be largely ‘baked into’ asset prices. The move confirms the Fed will remain the test case for whether any central bank can ‘normalise’ rates. We expect it to try, but fail, with the funds target peaking out in 2017 at just 1% - way lower than the near 3% in the Fed’s own ‘dot plot’ rate assumptions.
Admittedly, monetary policy in 2017 will play second fiddle to politics, once Mr Trump’s new administration gets its feet under the table in January. But, even the volatility that could accompany a Trump-led paradigm shift does not point to an aggressive Fed.
Loose fiscal policy will come on top of – not instead of – a loose monetary stance...
First, it could be a year of two halves. The likely short-term growth stimulus from Mr Trump’s sizeable fiscal expansion could then be muted by the threat of widespread protectionist policies - at first locally, then spreading internationally.
This would be exacerbated if there’s rising perception of a US government debt rescheduling and/or interference in the Fed’s decision-making - though the former seems unlikely given Congressional objection, and the fact the $19tn of debt is denominated in USD.
Second, in theory, the case for tightening monetary policy may build in 2017 if protectionist overtones raise the spectre of inflation. But even under this scenario, the emergence of the ‘wrong sort’ of inflation – cost-push caused by goods and labour shortages, rather than demand-pull - would make any knee-jerk Fed tightening, if at all, short lived as the US economy ‘stagflates’.
The ‘wrong sort’ of inflation...
Third, Mr Trump’s threats to increase the deportation of illegal immigrants could, unless offset, accelerate the shrinking labour supply. This threatens the element in short supply during the US’s official seven-year business expansion: stronger potential growth.
The OECD expects potential growth to be just 1½%yoy in 2017 - no better than the current recorded growth rate. FOMC doves argue that this slow growth and overcapacity warrants a much lower ‘neutral’ (or ‘Goldilocks’) policy rate than in past recoveries.
Part of this puzzle is linked to disparate trends in worker participation rates. The US’s unemployment fall has been widespread, but the labour pool is shrinking. This is keeping the worker participation rate close to a 36-year low, in stark contrast to the steadily rising labour forces in the UK, euro-zone and Australia for example.
Such a cut to the labour pool could further spur wages. Yet, the hit to consumers and firms from the cost-push inflation that protectionism spawns suggests any demand-lift from a more isolationist US will be short-lived. In which case, the FOMC may be loathe to hike again - especially with some of the Fed presidents who voted for today’s hike, next year losing their rotating voting-status.
So, we continue to look for a maximum funds target rate in this cycle of just 1% - way lower than its historic average of about 5%. And, with the window to hike likely to remain relatively small, this makes the FOMC’s preference for a-close-to 3% peak rate after 2018 look increasingly unrealistic.
Mark Sherlock CFA, Lead Portfolio Manager, US Small and Mid Cap:
Implications for US SMID stocks
A direct effect of higher short-term rates is a further increase in long-term bond yields, which had risen in expectation of the decision, and will help improve the profitability of regional banks.
More broadly, US small caps typically outperform large caps during interest-rate tightening cycles as they are more heavily exposed to domestic growth. From 1963 to 2012, small companies generated an average total return of 13% in periods when interest rates rose, compared to the 8.1% return from large companies1.
As rates tighten, the stimulus measures announced by US President-elect Donald Trump should benefit US SMID companies, particularly those in the following sectors:
• Materials: the $1tn pledged to infrastructure investment will benefit aggregates suppliers and other companies linked to road construction
• Energy: less domestic regulation, and OPEC’s commitment to cut production, should benefit shale oil and gas producers
• Industrials: a cyclical upswing is typical of a pro-growth environment
• Banks: higher short-term rates, less regulation and a steepening yield curve will benefit regional lenders
US SMID stocks are currently valued in line with their long-term average, with the Russell 2500 trading on an 18.5x 12-month estimated forward price-to-earnings multiple. The S&P 500’s multiple of 16.9x means that SMID companies are trading in the range of their average premium of 2x over large caps.
We believe that the combination of higher US rates and fiscal stimulus is creating a new investment environment where convincing opportunities exist down the market-cap spectrum.
- 1 WSJ Research as at 2014
Downside defence: yesterday’s strategy won’t work tomorrow
Euro-zone – time for Plan B...