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Will a Fed Rate Rise Mean the US Stock Market Falls?

The Federal Reserve is expected to raise interest rates next month. Will this trigger a correction in US equities - a market which is looking increasingly expensive

Emma Wall 25 May, 2017 | 11:41AM

 

 

 

Emma Wall: Hello, and welcome to the Morningstar series, "Market Reaction." I'm Emma Wall and I'm joined today by Henderson's Paul O'Connor to talk about U.S. equities.

Hello, Paul.

Paul O'Connor: Hi, Emma.

Wall: So, many investors, myself included, have done pretty well out of the U.S. equity bull market. But things are starting to look toppy now. Have we seen the beginning of the end for this bull run?

O'Connor: Well, it's certainly been a long expansion. You know what, I guess, eight years into the bull market in equities, eight years into the bull market in credit and the U.S. has led the way. So, it's only natural at this stage of the financial and economic cycle to begin to think that returns are going to get lower and volatility is going to pick up. And we're beginning to see some episodic bouts of volatility over the last couple of years, but markets have still delivered quite decent returns.

Valuations though do tell us a lot about where returns are going to be over the medium term. They don't tell us a lot about the short term. And certainly, when we look at the U.S. equities today, we'd say the current valuations imply that returns are going to be pretty modest over the medium term starting from here. There are more attractive markets we can find elsewhere where expected returns will be higher.

What happens over the next few months, the new few years, I think is much less about valuations. Valuations' predictive power is best over the next 5 and 10 years. I think what happens in the next few months and next few quarters, I think it's going to be a lot more about the Fed and a lot more about the macro momentum.

Wall: And of course, market timing is famously difficult to get right. But you mentioned the Fed there and that may well be a trigger for this correction because the Fed has indicated and indeed markets are pricing in a rate rise next month in June. And as bonds become more attractive from a yield point of view, that may well see a drawdown in equities as those people who are forced up the risk scale can go back into that perceived safe haven of T-bonds?

O'Connor: It's a possibility. I think the Fed and central banks more broadly have had a tremendous effect on financial markets, the post-crisis environment, particularly on the valuations side. And when we look at equities, we typically see three stages to that cycle. Early in the economic cycle when the central banks are easing, valuations go up. Towards the end of the economic cycle where the central banks are tightening, valuations tend to come down.

Where we've been in the last year is in the mid-cycle where the central banks go relatively quiet and it becomes much more about earnings growth. And I'd say the story of this year has really about that. The central banks are doing an awful lot and the earnings growth is coming through. So, markets are almost beginning to disregard the central banks thinking what they do will be quite modest and will have a modest impact.

And instead, they are celebrating the fact that we're getting fairly decent earnings growth even in the U.S., although the growth is stronger elsewhere. But the Fed will tighten. There is a good change they will tighten in June. They've begun the discussion on the tapering as well. And I think it is the beginning of the end of this great era of monetary expansion and also valuation expansion in markets.

I don't think it means returns are going to be negative in equities. So, I think, in a sense what we have to balance is the improving macro momentum, which is a positive of course, against the fact that we've had the best of the central banks. And if market expectations are broadly appropriate, the Fed are going to hike maybe once or twice this year and a couple of times next year, I think equity markets can withstand that because we're getting fairly decent earnings growth coming through.

But we are at the stage of the cycle where it becomes a bit more complicated, where good news on the macro front is great for earnings, but it's also bringing some pressure for the Fed tighten. I think the balance we have at the moment that we're fairly constructive. We're getting decent growth and Fed can still proceed at a very gradual pace.

Wall: So, not negative returns in the U.S., but perhaps not the best place to buy right now. Where are the greatest opportunities globally?

O'Connor: That's right. I think in a relative sense, we prefer equities to other asset classes, certainly over credit and government bonds. And regionally, I think, amongst the major markets the U.S. looks the least attractive because the economic cycle is most advanced. We have the Fed to contend with.

Europe is probably where we like most. We like Europe, we like EM, we like Japan. Europe, we like most because we have the best macro momentum. You're getting upgrades to growth, upgrades to GDP. You have a central bank that's going to remain accommodating for quite a long time and you have a market that although investors have started to put money into Europe in the last couple of months, they've spent the previous two years taking money out. So, I don't think positioning is very advanced.

And also, when we look at Europe, we can see potentially quite a significant medium-term story in terms of earnings recovery. Corporate earnings in Europe are still something like a quarter of the pre-crisis peak when of course all these measures in the U.S. look very much at peak at the moment suggesting limited scope for expansion. In Europe, we're quite early in the expansion and if the macro momentum continues in the fairly broad way that we've seen of late, I think this could be a multi-year earnings-driven story in Europe, which certainly looks a lot more attractive than the fundamentals we see in the States where there's a lot more limits to the potential for equities.

Wall: Paul, thank you very much.

O'Connor: Thank you, Emma.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Emma Wall  is former Senior International Editor for Morningstar

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