Banks aim to limit pain of rate rises

Financial markets are, according to wealth managers, about to witness the end of an era: the first rate tightening since before the credit crunch by the central bank which oversees the world’s most powerful economy. Most private bankers expect the US Federal Reserve to raise the the target range for its benchmark rate – currently  zero to 0.25 percent – later this year, with many singling out September as the most likely month. 

Many have seen the anticipated rate rise from the Fed as a reason to reduce allocations to US stocks, because a higher cost of borrowing hits stock prices by damaging corporate earnings. But wealth advisers are left racking their brains to find ways of profiting from the dollar strength that is likely to result. 

There is, however, a key difference in the way wealth managers are treating this start to monetary tightening, when compared with upward interest rate cycles of the past. 

Fears of Fed tightening choking global growth are currently low. Optimism is based on the fact that much of the rest of the world is expected to maintain an opposite course of extreme monetary easing. Moreover, most wealth managers expect only a moderate pace of monetary tightening in the US itself – reducing the chance of severe damage to US growth. This expectation was given credence in June, when Fed chair Janet Yellen indicated the Fed would raise rates only gradually. 

“I don’t think we’re going to see a big revolution,” says Mads Pedersen, co-head of asset allocation at UBS Wealth Management in Zurich. “I think the Fed will make one or two hikes to see how it goes – if we get much more than 100 basis points in the first year, I’d be surprised.”

However, wealth managers are united in warning against complacency – against being sure the Fed can engineer a smooth exit from easy monetary policy, regardless of what goes on in the world outside. “Geopolitical and social risks have increased considerably,” says Stephane Monier, chief investment officer for Private Banking at Lombard Odier Europe. 

For example, “a crisis in the Middle East could push up oil prices. This would reduce the potential growth of the US economy while increasing inflation, giving the Fed some sort of dilemma between inflation and growth,” says Mr Monier. The choice would be between raising rates to stem inflation but at the risk to growth, or leaving rates as they are to protect growth but at risk of letting inflation surge. 

It is all the more difficult to be sure of exactly what will happen because, he says, “we’re in experimental economics – we’re coming to a point where two central banks” – the Bank of England as well as the Fed – “will begin to remove some of the liquidity.”

Despite their uncertainty, wealth managers have to work on base case scenarios. “In the next two years we will see maybe three or four rate hikes, and then we will have to wait and see,” says Michael Strobaek, global chief investment officer in the Private Banking & Wealth Management Division of Credit Suisse in Zurich, whose base case scenario of a rate rise in September is followed by a very slow pace of rate rises after that.

This dovish view is based on his assessment that the US is in “an environment of very benign inflation rates and expectations”. Continuing balance sheet repair, an ageing population and the disinflationary effect of technology are all suppressing US inflation, believes Mr Strobaek. 

“Rate hike cycles normally take value out of equities, but we don’t think this rate hike is going to derail the mild equity bull market that we’re in,” he says. “Because of the backdrop of economic growth, we think equities can stomach this.  So in the second half of the year we think equities will resume their previous upward trend” – although the US may underperform other regions. Mr Strobaek likes bank stocks, which can benefit because the prospect of slow Fed rate rises will keep the yield curve steep. 

Banks typically benefit from steep yield curves because they tend to borrow at short-term, but lend at long-term, rates. As a consequence they tend to outperform other stock sectors when rate rises are expected. On the other hand, Credit Suisse is avoiding classic defensive stocks, such as utilities and telecoms, whose value tends to fall with rate rises, because investors treat them largely as bond-like, yield-bearing instruments. 

Credit Suisse also advocates sizeable allocations to countries with very accommodative monetary policy, such as Switzerland, where it changed allocations to overweight in May, and Japan. However, it sees valuations in the eurozone, where the European Central Bank is engaged in quantitative easing, as too high. 

UBS echoes Credit Suisse in believing US rate hikes will not choke global stockmarket growth. However, while UBS is, as Mr Pedersen puts it, “long risk globally, including stocks,” it has moved around some of its allocations. “Late last year we were overweight US stocks and neutral on the eurozone – but now our overweight is not in the US but in the eurozone,” says Mr Pedersen. “We are moving our positions in response to actions of central banks.” The ECB began QE in March. 

Lombard Odier has taken a more extreme position, by reducing US equities to underweight. For example, its European Balanced Accounts have a strategic asset allocation of 12.5 per cent to US stocks, but a current allocation of only 7.5 per cent. This is based on assessment that higher interest rates will reduce corporate earnings by slowing the US economy and increasing the dollar’s value.

The US economy is facing headwinds, with several wealth managers mentioning strength of the dollar – boosted by expectations of Fed tightening, in contrast to continuing ultra-loose monetary policy in the eurozone and Japan. Société Générale Private Banking forecasts corporate earnings growth of just 1.5 per cent this year in the US, in line with consensus. This compares with consensus eurozone forecasts of 17 per cent. Eric Verleyen, London-based CIO, cites both the strong dollar, which hits dollar values of overseas earnings and saps competitiveness, and the slide in capital investment by the hard-hit oil sector. 

Despite this, SGPB retains the neutral stance it has had since the beginning of the year on US stocks. “Clearly the story for US stocks is less attractive than eurozone stocks,” he says. “But for the sake of diversification, we still like to hold US equities, which are also supported by a likely rebound in the US economy from first-quarter weakness, and by a lot of stock buybacks.”

The dollar headwind is, of course, a tailwind for countries whose currencies have become substantially weaker against the dollar because of the expected divergence in monetary policy. Eurozone stocks have gained from the sharp slide in European currency against the greenback between May 2014 and March of this year, though the euro has rebounded slightly since then. 

SGPB has also allocated money to parts of the Japanese stockmarket benefiting from yen weakness against the dollar and other currencies, as the central bank continues to fight to reintroduce inflation into Japan. 

“We like exports, and sectors connected to tourism,” says Mr Verleyen. “There’s more and more tourism in Japan because of the weaker currency.” He cites airlines and amusement parks as examples. 

In common with SocGen, Florent Bronès, chief investment officer of BNP Paribas Wealth Management in Paris, also predicts continued dollar strength. He is confident the dollar will strengthen against the euro, with a target of $1.05. The euro was trading at $1.13 in early June. 

Investors face a problem, however. Treasury bonds offer unacceptably low yields for investors, and are prone to falling in value if the Fed raises rates more than expected. US high-yield, popular with European wealth managers in recent years, is at risk of seeing falls in value of the principal for the same reason. High-yield is, in addition, at an awkward juncture, says Mr Bronès. 

“US companies are more advanced in the credit cycle, so they are more leveraged than European companies. They also have high sensitivity to oil prices,” he says, adding that US high-yield funds have suffered from the disastrous performance of shale producers’ debt, following the drop in the oil price. 

This leaves US stocks, but far from seizing on them for want of anything better, Mr Bronès is positively enthusiastic. “US equities are one of our favourite investments,” he says. “We’re overweight in most mature equity markets, but especially the US and eurozone.” 

Investment must be selective, of course. “If you expect the dollar to be strong, you’re not going to buy companies sensitive to the strong dollar, but instead, companies that are more domestically orientated.” This includes small and mid-cap stocks, which have the added virtue that they are likely to be boosted by strong M&A activity. 

BNP Paribas and other managers have distinctively different views, even though these are informed by a common belief that the Fed will raise rates a few times. There are, however, contrarians who do not see a rate hike this year, and are doubtful about whether there will be significant rate hikes in the next few years.  

One of these contrarian wealth managers is London & Capital. “We’ve just had a warning from the IMF to the Fed, saying it should delay its rate rise to the first half of next year,” says Ashok Shah, investment director at London & Capital. 

“We’ve had that view for a considerable period of time. The ability of the system to sustain meaningfully higher rates does not exist because it will just increase non-performing loans and destabilise the housing market and consumer spending.” 

This dovish view on US rates is in line with L&C’s bearish view of rich-world economies as a whole. “The debt crisis was solved by increasing the aggregate debt in the system, so developed markets will have an extraordinarily long period of low interest rates, and probably a long period of low growth and inflation to accompany that,” says Iain Tait, head of the Private Investment Office at London & Capital. 

“Our focus should be on assets that can create high and sustainable free cash flow, so that they are harnessing very good income streams in a low interest rate environment,” says Mr Tait, laying out his investment view in response to prolonged low rates. Examples of such companies invested in by L&C include US consultancy Accenture and UK clothing retailer Next. By contrast, L&C avoids companies that take on debt to boost growth, because slow economic growth means necessary demand is not there. 

If L&C is right, the greatest fear for wealth managers is not whether Fed rate rises will stop acceleration of developed-market economic growth. It is, instead, whether there is potential for strong developed-market growth in the first place.