By Douglas R Terry, CFA
US monetary policy is the major driver of the global cost of capital. As a Fed rate cycle approaches, we see the effects of raising required returns across the globe. The increased volatility is a reflection of investors' changing return requirements, risk assessments and the associated unwinding of leveraged exposure. As we approach the anticipated Fed rate hike, look for the earnings yield in stocks to rise (P/Es to drop) setting us up for an initial risk of a drop in equity prices on the magnitude of 10-25%.
But watch for an eventual rise in underlying earnings which will overcome the multiple compression and lead to new highs. On the bond side beware that a one year rise in the 10yr yields to 3.25% would equate to about a 7% loss in 10 yr bond positions. As for commodities, supply, the strength of the dollar and the unwinding of leveraged carry trades would seem to be the factors leading to the continued bear market. Expect the trend to continue and remain underweight.
Our strategic macro economic research partner released this month's asset allocation recommendations with a 6-12 month time horizon.
Key Macro Drivers:
- Trade and manufacturing are middling to sluggish
- Services and household confidence and spending are firmer
- Inflation expectations retreating with oil and other commodities
- Lower oil and commodity prices is a positive for the world's major economies, the late 1990s is a recent example
- Chinese equity slide - Not likely to affect Chinese economy
- Greece - Off the radar but not solved
- Sluggish global trade - Rising US import volumes a good sign
- **Rising interest rates in the US and high levels of debt globally