Assessing expectations

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US interest rates have been tethered to record lows for the last six years. When rates were originally cut to these levels, they were predicted to return to normal within a year. Six years later, we’re still waiting.

But at the Federal Reserve’s latest meeting, the US central bank dropped its pledge to be “patient” before raising interest rates, opening the door to the first rise in official borrowing costs in nearly a decade.

With the Fed meeting once again this week and as we move towards the ‘normalisation’ of US monetary policy, investors are understandably keen to see what the impact will be on individual assets. Mike Turner, head of Multi-Asset Funds, looks at the potential impact on various asset classes.

Currencies

Even before any rate rises have taken place, the most obvious beneficiary has been the US dollar. The currency has risen more than 12% this year on a trade-weighted basis, reflecting expectations of a rate rise at a time when two of the world’s other major central banks (the ECB and BoJ) are easing policy.

However, this has created something of a herd mentality and we may see that when a rate rise does eventually materialise, that it has been fully priced in to currency markets. After all, when rates do start to go up they will probably do so only gradually.

Developed market equities

One of the effects of the US dollar’s surge has been to effectively tighten financial conditions by lowering import prices and reducing US export competitiveness.  Although recent corporate profits announcements have been encouraging, analysts have been cutting forecasts for future earnings.

Amid rising share prices, future valuations have become less appealing. Furthermore, given the miserly payouts available from bonds and cash (in a growing number of cases yields are now negative), investors have been taking increasingly large positions in equities.

As a result, any unexpected bad news, including bigger-than-expected rate rises, could hit equity markets disproportionately hard.

Emerging markets equities

Emerging markets with currency links to the US dollar have already felt the impact of its strength. Some risk remains, although the relative underperformance of many emerging countries has created some attractive-looking valuations and possible investment opportunities.

Increasingly with emerging markets, it’s important to adopt a more ‘granular’ approach, making decisions on a country-by-country basis. It no longer feels as relevant to talk about “emerging markets” as a single entity. There is an array of factors affecting different emerging markets in different ways. Dollar strength is just one of these factors.

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