Following the dovish rate hike by the US Federal Reserve, one of the markets’ main concerns has eased, and may result in a tactical bounce. In our view, this will be followed by more muted, but positive momentum in equities in 2016, driven by gradual earnings growth. However, continued weakness in oil and basic materials will probably cap the potential for a sharp rally. Similarly, in credit we worry about rising default rates and falling liquidity. As a result, we continue to focus on quality and diversification.
With the Fed meeting behind us, we hope that we can start looking ahead. More importantly, we hope that markets can start looking elsewhere and be less obsessed with interest rate policy and trade on a broader set of fundamentals, including economic growth and earnings potential.
In fact, we believe that there are three scenarios for stocks.
- In the first scenario, where economic growth was too weak or global uncertainty too high for the Fed to hike rates (as in recent years), we had seen that the upside potential for equities had become more limited.
- We believe we are now transitioning to a second scenario, where there is more of a balance between policy support and economic growth, which we think will boost confidence about earnings. Since 1975, the start of a new interest rate cycle generally boosted equities in the following three, six and twelve months as a result of improved economic growth. The biggest rallies occurred in cycles where markets had anticipated the interest rate hike, as they have done in the current cycle.
- The third scenario, where economic growth is so strong that interest rate hikes need to be accelerated, potentially hurting stocks, is now a new risk scenario, but not our core view.
We thus maintain an overweight position in equities, but with a preference for the Eurozone as valuations there are more attractive than in the US and the European recovery is underestimated, in our view. Earnings growth expectations stand around 7% for both the US and the Eurozone in 2016, which we think, is reasonable in the Eurozone because of a low earnings base, while somewhat more difficult to achieve in the US due to potential wage cost pressure. Valuations are generally fair, but somewhat more attractive in Europe with a PE at 15x, compared to 16.3x in the US, according to consensus estimates reported by Datastream.
After a 7-year long wait and many incorrect and premature predictions, the Fed finally hiked interest rates on 16th of December. While the prospect of higher rates had frightened markets for several years now (starting with the ‘taper tantrum’ in 2013), markets rallied after the meeting. In our view, this can be explained by more cautious investor positioning and the build-up of speculative shorts ahead of the meeting. The need to cover these speculative short positions, post the Fed meeting, fuelled the rally further. In addition, the Fed went through a lot of effort to sound dovish, repeatedly stating that rate hikes would be gradual, that there are downside risks to inflation and that they have no intention of shrinking the size of their Treasury holdings any time soon.
With emerging market (EM) currencies, bonds and stocks being particularly sensitive to the interest rate outlook and USD, it is no surprise that we are seeing a bounce in valuations, especially after recent underperformance. We would not be surprised to see some further improvement in the short term and believe there is indeed some value in EM. However, we remain selective as we think that many countries face long term obstacles to growth, largely related to the build-up of debt in the private sector. Lately, economic momentum in several countries has become less negative, but we do not foresee much improvement. As a result, we continue to focus on investment grade and crossover (BBB/BB rated) companies in the bond market, and have a geographical preference for Asia in our EM equity portfolios.
We see two principal hurdles to sentiment in coming months, which will somewhat cap the rally, in our view, and keep us from adding more risk to our model portfolios for now. We worry that oil prices may remain volatile and that high yield may continue to send a cautious message to investors. Although, for now, we do not think that the rout in high yield is pointing to any systemic credit crunch.
- Oil prices have continued to drift down, mainly as a consequence of overproduction, while global oil demand is actually relatively resilient. US crude oil inventories are already near record highs, and in recent weeks, they have started to grow again, and at a more solid pace than is typical for this time of the year. Neither OPEC nor other producers have provided any tangible plans for production cuts, and hence, oil prices could remain volatile for a while. While lower oil prices may be good for the consumer, the immediate negative effect on the energy sector has in recent months been a drag on stock market indices in most markets. In emerging markets in particular, the effect of lower oil prices is overwhelmingly negative (with some rare exceptions, principally in Asia) and the risk of lower oil prices thus partly offsets the boost provided by the dovish Fed message.
- Credit spreads have widened sharply in recent weeks, especially in US high yield. High yield has been trading weak for a while, in line with our expectations and our preference is for investment grade and crossover credit (BBB/BB) over high yield. Globally, high yield was impacted by rising equity volatility, while in the US, this was further exacerbated by re-leveraging of balance sheets, the high weight of oil and materials in the US market and of course fears of higher interest rates. Many high yield funds had seen outflows in recent months and at least one fund had to restrict redemptions as investors were taking money out more quickly than the fund could liquidate positions. Liquidity in high yield has become much more limited ever since the credit crisis, as we have discussed many times before. Therefore, although the dovish message of the Fed should be a positive for credit, we continue to focus on quality, especially as we think that the default rate has started a steady upward trend that could last through 2016 and be particularly punitive for lower-rated high yield.
In summary, we are not making any changes to our model portfolios, our equity or bond allocations, or our regional preferences.
We believe that the dovish message from the Fed, and the relief that the first interest rate hike is finally behind us, are likely to lead to positive market momentum in the short term.
However, our enthusiasm is tempered by the challenges posed by continued oil price weakness and credit spread widening. We thus continue to focus on quality, with a preference for the Eurozone in credit, equities and currencies.
Jose A. Rasco is the Chief Investment Strategist for HSBC Private Bank-Americas. He is a member of the Global Private Bank Investment Committee. This column is for informational purposes only. It consists of general market commentary and should not be relied upon as investment advice.