The Fed is ready for a rate hike in December - but we maintain our equity exposure
Even though the Fed will raise the interest rate within the foreseeable future, we will maintain our overweight in equities and expect further increases in the equity market.
By Bo Bejstrup Christensen, chief analyst at Danske Invest
The Fed is ready to raise the interest rate in December – this is clear in light of the latest labour market report. Throughout the year, we have warned that the initial raise would threaten positive returns in the equity market – nonetheless we have decided to maintain our moderate overweight in equities. Why?
Ever since the Fed surprised the market in October with the announcement that December was on the cards for the first interest rate increase, it has been discussed whether the key indicators would be strong enough to convince the Fed to make its move. In our view, the nail in the coffin was last Friday's very strong labour market report, which not only surprised the market regarding the development in October, but also led to an upward revision of employment in the private sector in the preceding months. The labour market therefore appears significantly stronger than it did just a few weeks ago. We thus believe that the Fed is ready to raise the interest rate in December, exactly seven years since it was last changed–back in the dark days of December 2008 when it was set at zero.
All through the year we have warned that the first rate hike would be a threat to equities. Not because we expect a major disaster in the form of a new recession, nor because we consider it a mistake to raise the interest rate, but simply because the first raise following a sustained period with almost zero interest rate marks the beginning of a new regime – resulting in it being an event that has drawn a lot of attention.
Nonetheless, we will maintain the moderate overweight in equities we established at the end of September/beginning of October. Why? Simply because the factors that are now causing the Fed to raise the interest rate are exactly the same factors that we expect to push equities up higher from now on – and into 2016.
Growth has declined – to gear up again
We believe that growth in the USA fell from around 3% this summer to just below 2% in the early autumn. This weakening surprised us (we expected stable growth), but going forward we are very confident that the decline in growth is temporary. In rough terms, we believe that companies were affected by three negative shocks – the tightening of financial conditions, including the strengthened currency, the concerns regarding China and the emerging markets, and the new drops in oil prices. This resulted in an inventory correction – i.e. a period in which companies reduce production in order to trim their inventory. In future, it is vital that production increases, provided that companies do not experience a new decline in demand, to avoid that inventory reductions reach unsustainably low levels.
Furthermore, the American housing market continues to improve and we see several indications of moderately increasing wage inflation, which helps ensure strong domestic demand. As the price of oil stabilises, the financial conditions (a combination of yield spread, currencies, equities, etc.) are not tightened at the same rate as before, and growth in China improves, these shocks will diminish and thereby ensure increasing growth. We thus expect an increase up to 2.5% in the short term and potentially even greater acceleration during 2016, if the oil price remains fairly stable and China improves moderately, in line with our expectations.
Positive outlook for global equities
Increasing growth will not only convince the Fed that it can start the tightening process, but also assure investors that the economy is sound. Finally, it is important to us that the bond market has factored in that the first rate hike will take place in December. So even though we disagree slightly with the market on how many rate hikes will be undertaken in 2016 (we estimate four and the market only around three), they will occur in the context of stronger growth.
We thus assess that the outlook for global equities is positive – higher growth in the US, high and stable growth in the euro area and a moderate improvement in China will, in our view, ensure continued increases in the equity market into 2016.
