Fed flip, market flops?

In recent months investors could be forgiven for sitting on their hands. By clearly telegraphing a rate increase in Q3 15, US Fed policymakers predictably added to upward pressure on the US dollar and created the conditions for capital flight out of China and other emerging markets.

Exhibit 1: Yields jump on US 2y Treasury notes Source: Datastream

The negative equity market reaction initially led Fed policymakers to confirm investors’ much reduced US interest rate expectations in September, Exhibit 1, leading to a powerful rally in global equities. In the circumstances, October’s Fed statement was an unpleasantly hawkish surprise; interest rate expectations afterwards shifted rapidly higher as the US policy focus returned to domestic issues such as strong payrolls growth. For example, the yield on 2-year US Treasury notes has risen by nearly 30bps since the end of October.

Exhibit 2: Divergence drives euro lower Source: Datastream

As a result, the policy divergence between the world’s central banks has now widened considerably. Recent comments from ECB President Mario Draghi indicate that the weakness in emerging markets is still being taken much more seriously than at the Fed. In particular, the asset purchase programme is “considered to be a particularly powerful and flexible instrument”. With hints as clear as this, the announcement of additional QE in December is effectively a given. In the UK the BOE has indicated that it may tolerate a modest overshoot of the inflation target. These developments have renewed the upward pressure on the dollar, notably against the euro which has fallen by over 5% since the end of October, Exhibit 2.

Outside the FX markets, the equity rally has been all but snuffed out following the Fed’s statement. Investors are not only re-evaluating interest rate forecasts, Exhibit 1, but are also contending with a sharp loss of earnings momentum across all regions, Exhibit 3. Our caution in terms of equities stems from the combination of relatively high median valuations and distinctly modest forecast sales growth on a global basis. The downward profits revisions which are coming through as world GDP expectations ebb may not be unexpected but highlight the relatively low expected returns on offer in equity markets. The high-profile profit warning for Rolls Royce may have been at least partly self-inflicted but weak results at IMI on the same day link directly back to the common factor of capex reductions in the energy sector.

Exhibit 3: Global earnings momentum declines Source: Datastream

In August, we highlighted that a monetary policy response was likely to be forthcoming to offset the EM growth shock, even if talk of further US quantitative easing always seemed premature to us in the circumstances. But after dovish comments in September, the most recent and distinctly hawkish FOMC statement in October has stopped the global equity rally in its tracks. We believe global equity markets will struggle to make progress as December approaches, unless economic sentiment outside the US can improve sufficiently to close the monetary policy gap and ease pressure on the dollar.