US INTEREST RATE HIKE. HIGHLY ANTICIPATED…OR NOT?

AFTER A 7 YEAR WAIT The U.S. Federal Reserve (Fed) finally raised its key interest rate to a range of 0.25% to 0.5% from a range of 0% to 0.25% on 16 December 2015. This was after a 7-year period of near-zero interest rates to support the recovery of an economy that was hit by the global financial crisis in 2008. US Chart

WHAT HAPPENS WHEN THE FED HIKES INTEREST RATES

Raising rates is one of the tools that the Fed has at its disposal to keep the US economy on track. The Fed’s mandate is to smooth out the economic cycles and promote “maximum employment, stable prices, and moderate long-term interest rates.”

The Fed is essentially making ‘money’ more expensive by raising rates. Higher rates mean higher borrowing costs for companies that need capital to build factories, or for consumers looking to buy a new home. A rate hike also means higher returns for investors that are lending their money.

SENTIMENT OF THE US ECONOMY

Global markets reacted positively following the announcement by Fed Chairwoman Janet Yellen.

We believe this is due to strong signals of an interest rate hike that were communicated by the Fed in the last few months. The expectation of a rate hike was thus priced into the market already. We also expect a 25-basis point rate hike to have little impact on the economy. There should be some changes in short-term borrowing rates. But loans linked to longer term interest rates are unlikely to move much, if at all.

The Fed shared in its press release that “…the Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.”2

What this means is that the Fed is concerned by sentiment in the market. The Fed is signalling a new era for the U.S. economy with this rate hike.

Two questions come to mind during our analysis of this rate hike:

1) Can the US economy handle subsequent rate hikes?

2) What should we expect from these moves in the future, if any?

We feel that the Fed will keep future rate hikes to a minimum due to 2 factors:

1) After the 2007-08 financial crisis, the Fed started its quantitative easing (QE) program. Trillions of dollars were pumped into the US financial system to stimulate the economy.

 

QE seems to be a policy designed for the rich, by the rich. The impact of QE is seen in the rise in asset prices instead of the real economy. The wealthy – who own the bulk of financial assets – are the chief beneficiaries so far. Compare this to the sluggish economic growth in the US. Given the size of monetary expansion due to QE, real GDP only grew between 1.6% and 2.5%.  (Between the period 2010 to 2014) 3

2) The national debt of US is more than $18 trillion as of end FY2015.4 Raising interest rates will have an adverse impact on the economy as that will mean higher interest repayments on these debts.

 

The debt of non-financial firms in emerging market economies has quadrupled to more than $18 trillion in 2014 from $4 trillion in 2004.5 The International Monetary Fund (IMF) warned emerging market governments that should the Fed hike rates in the future, there will be an increase in corporate failures in their countries as firms struggle to meet higher borrowing costs. That could create distress among local banks who have bought a sizeable amount of this new debt.

 

The concern is that the Fed’s rate hike may lead to a boomerang effect. Further rate hikes will hurt the other economies, which could lead to greater economic woes for developing countries that will eventually hurt U.S. trade and economic growth.

HOW THIS AFFECTS YOUR PORTFOLIO

No one knows exactly how the market will react moving forward.  Our Investing Committee will continue to keep a close watch on the global economy – with special attention paid to the US. This will help us position your portfolio in the best possible way.

We believe being defensively prepared for a potential correction is the most offensive and appropriate approach you can adopt now. This is in light of the high asset prices (as seen in the major US indices and property markets) today and a slow, growing economy.

We have been advising you to allocate a portion of your portfolio to capital preservation assets since 2013. Holding on to more cash now will allow you to capture opportunities when they arise. We are currently waiting to cash out on some of your holdings to add to your capital preservation assets. In spite of that, we remain confident of your current and continued investments in oil and Chinese equities. They remain sectors that present great value at attractive prices.

Source

1 – Trading Economics

http://www.tradingeconomics.com/united-states/interest-rate

2 – Federal Reserve

http://www.federalreserve.gov/newsevents/press/monetary/20151216a.htm

3 – Statista

http://www.statista.com/statistics/188165/annual-gdp-growth-of-the-united-states-since-1990/

4 – US Government Debt

http://www.usgovernmentdebt.us/national_debt

5 – International Monetary Fund

http://www.imf.org/external/pubs/ft/survey/so/2015/POL092915B.htm.

 

 

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