• The Federal Reserve hiked rates for the first time in nearly 10 years, but borrowing costs are expected to stay low for an extended period.
• The ongoing resiliency of the U.S. economy positions it well to handle a gradual rate-hike environment.
• Financial-market volatility is likely to remain elevated, placing greater importance on investment selectivity.
For the first time in nearly a decade, the Federal Reserve raised interest rates, signalling its faith in the U.S. economic recovery and marking an end to a historic period of monetary policy accommodation. While the decision to raise rates by 25 basis points was widely anticipated, the ramifications – and opportunities – for global investors are notable.
The Fed’s action has garnered plenty of attention, but investors should be aware of what matters most, and that is the path of future rate hikes. The increase in borrowing costs may feel like a seismic change, but that’s primarily because it’s been so long since rates have been increased.
View the hike not so much as the Fed slamming on the brakes, but instead taking its foot off the gas pedal. The reality is that, by historical standards, rates are extremely low and are likely to remain so. Indeed, in announcing the hike to a range of 0.25% to 0.50%, the Fed said it expects rates to stay subdued, and that the hiking cycle will be gradual. High debt levels, questionable productivity growth, slow economic growth, aging populations, strong demand for high-quality assets and ongoing easy monetary policies elsewhere around the world will all likely contribute to keeping a lid on rates even as the Fed normalizes its policy. And the gradual nature of the tightening cycle should allow markets to absorb the increases with relative ease.
It’s also important to remember why the Fed is comfortable taking this action. By many measures, the economic recovery has not been a robust one, but today the U.S. economy is showing further signs of life. The most recent employment report, for instance, showed the U.S. economy created more than 200,000 net new jobs in November, while the unemployment rate held steady at just 5%.
Of course, as we’ve witnessed throughout 2015, financial markets are not immune to bouts of volatility, as evidenced by the recent tumult in high-yield markets. Economies outside the U.S. continue to struggle, and emerging markets are likely to remain under pressure, although some adjustment has already occurred in anticipation of rate normalization. Equities may also find it difficult to advance in the face of an appreciating dollar and stagnant corporate earnings, placing greater import on investment selectivity. And while we do anticipate the Fed will be gradual in bumping up rates, there can be no guarantees about the pace of increases and the final fed funds rate once central bankers are done.
Overall, investors should view the rate hike for what it is: good news and a testament to a resilient U.S. economy. Expect ongoing volatility, but remember that while rates are no longer at zero, they remain extremely low, and will likely remain low for some time. We prefer stocks, particularly European and Japanese equities, over bonds, and market-neutral strategies such as long/short equity and credit.
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