By Antoine Lesné
All eyes are on 16 December when the Federal Open Market Committee (FOMC) will meet and potentially raise interest rates for the first time in eight years. Should this happen, the implications for markets are huge.
Questions linger on the normalisation of treasury yields, but remain protected by the natural flow of US domestic pension plans, and foreign investors thirsty for positive real yields, acting as a shield to protect against any significant back up in yield. On the flip side, long term US breakeven inflation remains low in this lower for longer environment.
So what would an interest rate hike actually mean for investors?
Historically, certain asset classes and sectors have benefitted from such periods. Three trades investors should be considering right now are:
- US Treasury inflation-linked bonds
- US Consumer Discretionary Sector
- US Financials Sector
1. US Treasury inflation-linked bonds
Inflation-linked bonds issued by the US Treasury tend to be attractive when inflation surprises on the upside. As part of a broader bond portfolio, TIPS (Treasury Inflation Protected Securities) allow investors to diversify their portfolio and partially hedge against the negative impact inflation can have on nominal bonds; and while unemployment numbers remain strong this asset class can also potentially protect against a surprise increase in inflation as wage pressure may start to filter through.
2. US Consumer Discretionary Sector
Consumer discretionary should continue to do relatively well in this environment, as an increase in rates will not hamper consumers’ ability to spend. Meanwhile low energy and commodity prices continue to act as a tax cut, giving US consumers more disposable income.
3. US Financials Sector
Should interest rates rise US bank balance sheets will likely benefit, so investors would do well to have an exposure to US financials. Not only this, but interest-rate sensitive sectors – such as financials – will likely profit most in the early stages of recovery benefit when confident buyers increase their borrowing to buy cars, houses etc, while interest rates remain low.
What if rates don’t rise?
There are structural forces at play in the US. The buzz amongst more bearish market commentators is that China may lead the world into recession in 2016. For fear of hurting global financial conditions and sending emerging markets into tailspin, the Fed may continue to delay an interest rate hike believing it can fight inflation more easily if need be; potentially leading to a creep up in inflation.
Should the Fed not raise interest rates in December, against a backdrop of persistent low inflationary pressure in the US, we could potentially witness a flattening of the long end of the yield curve. By gaining exposure to long duration (10 year +) US corporates, investors can take advantage of credit spreads in this part of the yield curve through higher duration, and by harvesting the lower liquidity premium.
In addition to this, the US economy is expected to expand at around 2.5% in 2016. This phase of the economic cycle should remain favourable for corporate bonds. Investors looking for 5% yield can find attractive levels in the long end of the US investment grade corporate curve.
Global monetary policy continues to drive sentiment and asset class performance. Investors need to make sure they are positioned to benefit from it, whilst protecting against the downside.
Antoine Lesné is head of ETF sales strategy EMEA at State Street Global Advisors
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