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Fed Tightening: Who Can Better Weather the Storm?

Global equities tend to rally ahead of Fed tightening, with the USA underperforming and Europe outperforming. High yield bonds tend to perform well through the cycle. Emerging market bonds tend to rally ahead, and weaken after.

With US economic data strong, we stick to our base case of a first US rate hike as early as June 2015. As we noted in our prior analysis, world equities have tended to rise in the advent of such a US tightening cycle, with the USA underperforming, the dollar rising. US Treasury bonds tend to weaken mostly after the first hike, rather than before. Increased equity volatility tends to follow the initial hike, and the US dollar tends to correct weaker, but a global equity uptrend tends to resume within 1–3 months thereafter.

Here we address the conundrum as to why the USA, with the strongest economic growth momentum, may be among the weaker equity markets in this phase. We also ask which markets may perform better.

Earnings Multiple in the USA Tends to Fall During Rate-Hike Cycles

In the chart, we show that US earnings have grown strongly when the business cycle matured and the US Federal Reserve (Fed) started to tighten. However, the impact on equity prices tends to be absorbed by multiple contraction (i.e. a decline in the price-to-earnings ratio), with earnings rising more than equity prices. After a multiple expansion in preceding years – in expectation of rising earnings – we tend to see the opposite occur at this mature stage of the cycle. This is not just a "sell on the news" effect: the value of each unit of future earnings must be discounted into current prices via a higher interest rate, which will also hold back stock prices. A stronger dollar also tends to curb the impact of growth on US earnings in this phase. In contrast, although markets outside the USA may see less growth momentum, they benefit from lower discount rates, weaker currencies and a less mature earnings cycle, and so can outp! erform.

Europe and UK Equities Better, Emerging Markets Mixed, and US High Yield Robust

If US equity underperforms at this time, with risk of marked temporary setbacks, which markets will do better? While there is not such a clear pattern among non-US equities, Europe, and the UK in particular, tend to hold up relatively better before and after the first interest rate hike by the Fed. Emerging market (EM) equities also tend to perform relatively well on average, but with wide variation. More broadly, US high yield bonds have shown a robust performance both before and after tightening. EM hard currency bonds have typically shown a positive performance before the first rate hike, but underperformed significantly in the months thereafter.