A P: What happens when the Fed hikes?

The days ahead will see sharp volatility and large swings in investor sentiment

Global financial markets are in turmoil, with equity markets selling off across the world led by the emerging markets. Bond yields have also spiked with the 10-year bond in the US approaching 5 per cent. The dollar has also continued to strengthen against the euro and yen.

Cyclical sectors are significantly under-performing defensives. The cause of all this turmoil and churn is the belief that the US Federal Reserve is about to embark on a period of sustained tightening to normalise short term interest rates.

While everyone knew that keeping the Federal funds rate at 1 per cent was unsustainable and the Fed would have to eventually raise rates to more neutral levels, many observers had felt the Fed could wait till 2005 before moving.

The release of the April jobs report has forced everyone to bring forward the tightening timetable. The US economy generated 288,000 jobs in April (on top of a huge 337,000 in March), beating the most optimistic estimates and reinforcing the growing belief that the US economic recovery is now self-sustaining.

Over the last eight months the US economy has generated more than 1.1 million jobs, helping to lay to rest concerns that the economy will fade in the second half of 2004, post the phasing out of the stimulus received from tax cuts and mortgage refinance. The Federal funds futures market is pricing in a series of quarter point increases from the current 1 per cent, starting in June itself.

Assuming for a moment that the futures market is correct and a Fed tightening cycle is imminent, what does this mean for financial markets? What happens to sectoral and regional performance as well as the performance of equities as an asset class?

To begin with one must realise that a rising US interest rate environment over the past 15 years has been the exception rather than the norm.

There have been only three Fed tightening cycles over the past 15 years(13-month 300-basis point cycle starting February, 1994, one move of 25 basis points in March 1997, and a 12-month 170-basis point cycle in 1999-2000). For the vast majority of the past 15 years Fed rates have been either falling or stable.

It is tough to draw firm conclusions on how equities as an asset class will perform dependent as the results are on the reasons for tightening(a growth shock like in 1999 or to counter an inflationary surge).

Results also vary depending on the valuation and earnings level of the market. It is however far easier to see patterns at a sectoral and regional level.

Using data on all Fed tightening episodes since 1984(for a longer more robust data series, source: CSFB) we find that six months into a Fed tightening, cyclicals like mining and transport tend to significantly under-perform more defensive sectors like beverages and food products.

This sector rotation towards defensives is even more pronounced when the yield curve starts to flatten(interest rate spread between three-month and 10-year bond narrows)in response to the tightening cycle.

A combination of the initiation of a Fed tightening cycle and a flattening of the yield curve is almost guaranteed to lead to cyclicals under-performing defensive sectors.

One could argue that part of the sell-off in commodities and other cyclical sectors globally (beyond the China slowdown effect) is in response to investors beginning to position their portfolios for this eventuality.

Another very clearly documented effect of Fed tightening is its impact on regional performance. In five out of six Fed tightening episodes post-1984, Asia ex-Japan specifically and global emerging markets more broadly have significantly under-performed global equity markets.

The worst episode was the 1994 tightening cycle when Asia ex-Japan under-performed global equity markets by 1,200 basis points within the first three months following a Fed rate hike. Interestingly, in all six tightening episodes, the US equity markets outperformed global equity indices and that too by an average of nearly a 1,000-basis points within the first three months of a Fed hike(source CSFB).

Given the above data is it any wonder that investors in preparation for a period of Fed tightening are beginning to pull money out of emerging markets and Asia. Foreigners have been dumping stocks across the region over the past week. One can only expect this trend to accelerate as investors reduce their risk appetite and unwind leveraged carry trades.

Is there any reason to question this regional market performance pattern in this cycle? Can things play out differently this time?

While currently events are playing out pretty much to script (emerging markets including Asia being sold down aggressively and US outperforming) there are reasons to think markets may eventually diverge from history.

Asia in this cycle is a significant net creditor, running an aggregate current account surplus of 1.9 per cent of GDP and having huge forex reserves. In past tightening cycles, Asia always had large current account deficits and significant foreign currency borrowings at the corporate level.

It was much more vulnerable to rising interest rates and a reduction in short-term capital flows and investor risk appetite. In 2004 it is a very different Asia to what one saw in 1994 and therefore shouldn't investors treat it differently?

America, on the other hand I would argue has far greater vulnerability to rising interest rates in this cycle than ever before. First of all household debt service ratios (in the US) despite record low interest rates are at peak levels of over 13 per cent, in 1994 prior to Fed tightening the same ratios were below 11 per cent.

How will the economy and consumers react to rising rates is a source of considerable risk. Never before has household sector leverage been as high going into a Fed tightening.

Secondly financials in the US now account for more than 22 per cent of S&P 500 market capitalisation, the last three times the Fed hiked in 1999-2000/1997/1994, financials were only 14 per cent of market cap. US financials earnings also currently account for more than 30 per cent of S&P 500 earnings (if you include the financial earnings of non-banks like GE and GM this figure crosses 40 per cent). In previous tightening episodes this ratio was never higher than 15 per cent.

Given the extent of leverage in the financial system and the use of leverage for investment by a multitude of participants, any sharp volatility in interest rates can trigger a chain reaction. There is absolutely no doubt in my mind that markets and corporate earnings in the US have never been more vulnerable to rising rates.

All the above indicates to me that the US equity market should be far more sensitive to rising interest rates than the historic data would indicate.

While the Fed has yet to move on short rates, all signs seem to indicate that a move is imminent. The gap between nominal GDP growth and the nominal Fed funds rate at over 5 per cent is unsustainable and the real Fed funds rate being -0.7 per cent 10 quarters into an economic recovery is unusual.

When the inevitable tightening begins, expect cyclicals to under-perform and while Asia will also be sold off initially, there does exist a case in my mind for the region to do better in a relative sense than history would indicate, especially when compared to the US.

However, it will take some time for this thesis to work out (if it ever does that is!). Till then expect more days of sharp volatility and large swings in investor sentiment. Most global investors are still overweight emerging markets and Asia, but for how much longer?