Up until very recently, investors and the general public saw the American economy walking a path of moderate economic growth accompanied by low inflation levels. The crisis of 2008-2009 majorly influenced the Fed to adopt a policy of zero interest rates and monetary expansion in order to avoid a potentially large contraction in GDP. The Fed was successful in containing the aftermath of the financial crisis, allowing the financial system to recover and the stock market to bottom in March 2009. GDP growth, after a brief excursion into negative territory, has remained positive for the last 8 years.
The Fed began reducing its $4 trillion in Treasuries in October 2017. It had acquired most of these securities during quantitative easing, which ended in 2014. Although initially it said it would do so only after the Fed Funds rate had reached 2%, it anticipated this action (the Fed Funds rate is currently at 1.5%). Nevertheless, an increasing number of market observers sustains the hypothesis that U.S. interest rates may have already made a long-term bottom in 2016, from which they are now rising. U.S. 10-year treasury rates are already at 4-year highs:
The Fed expects to increase the Fed Funds rate to 2.1% in 2018, 2.7% in 2019, and 2.9% in 2020. Historically, rising or falling interest rate cycles last for decades. In U.S. economic history, they have lasted between 22 and 37 years. U.S. interest rates are currently close to four-decade lows:
For what reasons would interest rates rise at this point, and what would be the potential effects on American financial markets?
The Case For (And Against) Rising Interest Rates
The case for rising interest rates in the U.S. is based on three main premises:
- The Trump Administration’ s dollar and taxation policies
- A stabilising economy
- A tightening job market and its upward pressure on wages
The Trump administration has been vocally supporting a weaker dollar. At the World Economic Forum in January, Treasury Secretary Steven Mnuchin asserted that“ a weaker dollar is good for us as it relates to trade and opportunities.” Commerce Secretary Wilbur Ross commented that the U.S. would be more active in defending its trading interests, which was seen by investors as a sign of future protectionist measures. Since the inauguration of Trump, the USD has shed 15% of its value versus the Euro, which has risen to a 3-year high:
This in turned has stoked inflation fears, due the dependency of the U.S. on
imported goods. The US recorded a $53.1 billion trade gap in December 2017, the biggest since October of 2008. The USD has been also under selling pressure as c ommodities have staged a comeback. Oil is up 40% since June 2017 and has given back little as stock markets fell, further contributing to inflation fears.
The economic policies of the U.S. government need also to be taken into account. In December 2017 President Trump signed into law the "Tax Cuts and Jobs Act”, which l owers the corporate tax rate to 21% from 35%. Various observers have commented that such an expansionary measure at such a late stage in the economic cycle will inevitably lead to inflation. The Congressional Budget Office estimates the tax bill will increase the deficit by $1.5 trillion over the next decade and by $136 billion in fiscal 2018 alone, which would put upwards pressure on interest rates.
In addition, there are many indicators pointing to U.S. economic growth accelerating. U.S. economic growth in Q3 2017 was the fastest in three years at 3.3% YOY. The figure for 2017 was 2.3%, above the 1.5% of 2016. Every quarter in 2017 had faster growth than the corresponding quarter of 2016. Analysts expect this robustness to continue in 2018, with estimates pointing to a 2.9% increase. Manufacturing, a major job-creating segment of the economy, is also experiencing a remarkable period of growth. In September 2017 the ISM index recorded a 13-year high. Between 2013 and 2016 the manufacturing sector grew at about 0.5% per year on average, accelerating to 1.3% in 2017. The strengthening of the economy has pumped new energy into the labour market, the third pillar of the rising interest rate hypothesis. The U.S. unemployment rate stood at a 17-year low of 4.1% in January 2018, unchanged from the previous month and in line with market consensus:
On February 2nd the U.S. Department of Labor released data showing a significant increase in wages in January (+2.9% YOY). This was the fastest rate since Q1 2009. The job market also shows signs of tightening, with non-farm payrolls up by 200,000 in January, beating analyst estimates of 180,000. U.S. jobless claims dropped 7,000 to 222,000 in the week ending February 17th, a 45-year low:
On the other hand, many economic observers see the US continuing to experience disinflation or even outright deflation for the foreseeable future. This point of view is based on the base premises of:
- Labour Market Structure Demographics Technological advances
- Workforce participation has fallen since 2008 and has never recovered, standing currently at 62.7%:
An estimated 95 million Americans our out of the workforce, out of a population of 325 million. Despite the recent uptick, from a long-term perspective American wages are showing almost no growth. After adjusting for inflation, U.S. wages were only 10% higher in 2017 than they were in 1973, with annual real wage growth just below 0.2%:
An estimated 30% of American jobs (70 million) will be lost to automation by 2030, which would further put deflationary pressures on wages and weaken consumption.
The other main element to consider is that of ageing. The BIS warned in an August 2017 working paper that the ageing U.S. population, and the retirement of the “boomer” cohort, would dampen consumption growth for the visible future. The US fertility rate is at its lowest point since records began in 1909, while by 2030, those aged 65 and older will make up over 20% of the population. As older citizens have higher savings rate and lower incomes than those at peak earnings age (45-55), consumption and economic growth will be dampened, a scenario at odds with rising interest rates.
The Potential Effect of Rising Interest Rates on Equities
Against many predictions and a general sense of apathy, American equities have continued to post strong gains since the March 2009 bottom. From a low of 666, the S&P has risen to a high of 2,872 by January 2018, an increase of more than 300%. Investors have increasingly realised that in a investment landscape of perpetually low interest rates, the cash-flow and dividend income of American equities deserved an upwards re-rating.
The underlying equity fundamentals have nevertheless failed to keep up with rising valuations. The divergence has led to metrics showing a market close to its historical highs vis- à-vis earnings, sales, and book value. Overall S&P 500 earnings for 2017 were 124.94, an increase of 49.1% over the 83.77 of 2010. The S&P 500 between 2010 and 2017 however rose 115%, expanding the P/E ratio to above 20:
The Price/Sales ratio is also at multi-decade highs, despite no progression in profit margins:
Compared to GDP, market valuations are almost 2 standard deviations above the historical average:
The Shiller Cyclically-Adjusted PE Ratio (CAPE) for the S&P 500 stands at levels higher to those prior to the 1929 stock market crash:
In an environment of rising interest rates, how would equity markets fare?
It is informative to consider the events of early 2018 to understand what the future could hold. Treasury yields have climbed from a low of around 2% in September 2017 to 2.8% by the end of January 2018:
The market shrugged off the rise, gaining more than 15% during the same period:
The market saw the January wage and employment data as a potential harbinger of higher inflation and higher interest rates, and the S&P 500 proceeded to fall 10% in 5 trading sessions. This was a surprise move to many, as U.S. equity market have only experienced three 10%+ corrections since the March 2009 lows. The January correction was the also the first 5%+ correction in 312 days, a new record:
The relatively accommodative stance of the Fed has now been put into question by investors. The next rate-setting meeting, scheduled for March 20th, will be the first for new Fed Chairman Jerome Powell. Traders see a 71.9% chance of a rate rise and forecast this to be the first hike of up to 5 for 2018 as a whole.
On a longer-term perspective, U.S. markets have traditionally bottomed at the end of a long upward cycle in interest rates. This was the case in 1981, when the prime rate (discount rate) reached 16% and the Dow found itself at the same price level it had originally reached in 1964. They also tend to fall during rising cycles. The two more recent and protracted rate increases, the one between 2000-2001 and the one of 2007-2008, resulted in market corrections of more than 40%.
The current bull market is the 2nd longest in history, with a duration of more than 100 months days:
This is compared to t he average length of 48 months for previous bull markets. A rising interest rate environment at his point would be a significant obstacle to further price gains.
The Potential Effect of Rising Interest Rates on Fixed Income Markets
Just as rising interest rates are a headwind for equities, they represent the same obstacle for fixed income instruments. The U.S. government bond market is the largest in the world, with a cumulative value of $21 trillion. This represents approximately 32% of global government debt. International investors traditionally see U.S. debt as a safe haven from geopolitical instability and weakness in foreign economies. Treasuries are often the default asset of Sovereign Wealth Funds (SWFs) and institutional fixed income funds. Foreign investors, including foreign central banks, own approximately 37% of U.S. Federal debt as of Q4 2017:
This widespread ownership represents a potential danger for American debt prices and yield, where yields to rise rapidly. The existing stock of debt would depreciate, leading investors to liquidate positions to limit losses. On the other hand, newly issued American debt, at higher interest rates, may entice a simple rotation in the bonds of more recent vintage.
What is of fundamental importance to understand how foreign investors will act is the interest rate differential. The yield gap between Germany 10-Year Bunds and U.S. 10-Year Treasury yields recently reached a 10-month high. Even weaker EU economies, including Spain and Italy, have seen their government debt reach yields below their American equivalents. Although this is in part justified by anaemic economic growth, the effect could be of money being“ sucked” out of non-US debt and equity markets and redirected to U.S. treasuries. This in turn would cause a fall in non-US equity and fixed income markets. In addition, the cost of servicing dollar-denominated debts may put a strain on Asian or European companies relying on USD borrowing. According to the BIS, total dollar-denominated debt outside the U.S. reached $10.7 trillion in the first quarter of 2017, a third of it owed by the nonfinancial sector of emerging economies:
There have been various episodes in the last three decades were the rising costs of servicing USD-denominated debt have cause financial crises in emerging markets. Among them, the Mexican banking crisis of 1982, the Mexican financial crisis of 1994, the Argentinian financial crisis of 2001 and the Asian financial crisis of 1997. Emerging markets may find themselves again in a vulnerable position, with the debt of non-financial corporations having grown from $9 trillion at the end of 2008 to just over $25 trillion by the end of 2015, or from 57% of GDP to 104%:
A further element to consider is that of debt repayments. The U.S. debt to GDP ratio now stands at an all-time high of 105.4%. If an investor crisis of confidence were to occur over America’ s capacity to service its debts, interest rates would be likely to increase significantly.
Conclusion - Too Early To Say?
The end of the low-interest rate era has been announced on a regular basis since the financial crisis of 2008-2009. The Fed’ s normalisation of interest rates is under way and has not, to date, resulted in major financial turmoil or distress, either in the US or abroad. Nevertheless, the US discount rate is still only 1% above it’ s all-time lows, and far from the double digit figures of the late 70s and early 80s. Interest cycles in history tend to last decades, which would indicate this is the very beginning of an upwards cycle. With further dollar weakness and a strengthening economy, inflation may manifest itself and with it higher interest rates. This stage, however, has not as of yet been reached with any certainty. Equities are at all time highs and have very rich valuations, while bonds are at the potential tail-end of a 36-year bull market. A period of rising interest would therefore bode very poorly for both equity and fixed income returns in the foreseeable future.