Investment Clock insights

Economic Times February 2016


Ian Kernohan

2 February 2016

The US Federal Reserve (Fed) raised interest rates in mid-December, initially without much market reaction. The backdrop to the decision was an ongoing improvement in labour market data, most notably rises in employment and falls in unemployment, so the decision when it came, was no surprise: the Fed had worked hard to prep the market. It was only when investors returned in the new year that the fallout from the Fed’s decision really took hold.  The 2016 “wall of worry” began in China, a perpetual source of market “worry” for some time now, although the most recent phase of concern has centred around the vagaries of China’s currency policy, rather than a sudden shift in economic data. Fear then morphed into concern about a falling oil price (an unusual turn of events for those of us with long memories), before blossoming (bizarrely) into chat about a full blown US recession.

Meanwhile, the US labour market data continued to improve in January, even allowing for the temporary boost to construction employment from warmer weather in December, while the unemployment rate has now fallen to 5%.  The stronger dollar and the fallout from the weakness in the shale industry continues to impact the manufacturing sector, however we think fears of an oil induced recession look overcooked: the US is still net importer of oil and thus a beneficiary of cheaper oil, employment in the oil and gas sector is a tiny share of total employment, while energy related capex accounts for a relatively small (and falling) share of total equipment and structures spending.
Concerns about recession and a Fed policy mistake have led the market to become over cautious on the prospects of Fed tightening this year and the risks of upside surprise on Fed policy have now risen. The last three Fed tightening cycles saw rates rise by 150-250bp in the first year, and 175-300bp in the first 18 months. Given that the Fed are raising rates when other major central banks are actually easing policy (a key source of dollar strength), we expect the pace of interest rate hikes in this cycle to be much slower, however at time of writing, this is now more than priced into marketsThe US Federal Reserve (Fed) raised interest rates in mid-December, initially without much market reaction.  The backdrop to the decision was an ongoing improvement in labour market data, most notably rises in employment and falls in unemployment, so the decision when it came, was no surprise: the Fed had worked hard to prep the market. It was only when investors returned in the new year that the fallout from the Fed’s decision really took hold.  The 2016 “wall of worry” began in China, a perpetual source of market “worry” for some time now, although the most recent phase of concern has centred around the vagaries of China’s currency policy, rather than a sudden shift in economic data. Fear then morphed into concern about a falling oil price (an unusual turn of events for those of us with long memories), before blossoming (bizarrely) into chat about a full blown US recession.

Meanwhile, the US labour market data continued to improve in January, even allowing for the temporary boost to construction employment from warmer weather in December, while the unemployment rate has now fallen to 5%.  The stronger dollar and the fallout from the weakness in the shale industry continues to impact the manufacturing sector, however we think fears of an oil induced recession look overcooked: the US is still net importer of oil and thus a beneficiary of cheaper oil, employment in the oil and gas sector is a tiny share of total employment, while energy related capex accounts for a relatively small (and falling) share of total equipment and structures spending.

Concerns about recession and a Fed policy mistake have led the market to become over cautious on the prospects of Fed tightening this year and the risks of upside surprise on Fed policy have now risen. The last three Fed tightening cycles saw rates rise by 150-250bp in the first year, and 175-300bp in the first 18 months. Given that the Fed are raising rates when other major central banks are actually easing policy (a key source of dollar strength), we expect the pace of interest rate hikes in this cycle to be much slower, however at time of writing, this is now more than priced into markets.

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