Choose Language
March 22, 2018
BILBoardBILBoard March / April 2018 – Higher US rates on the horizon
Robust economic growth has increased confidence amongst Federal Reserve (Fed) officials that the US economy is ready for higher interest rates. Because interest rates affect almost every asset class in some way, rising rates have important implications for portfolio construction
The global growth story valiantly persists, though the scope for more positive economic surprises is lower. In the US, strength is visible across various data points, particularly the manufacturing PMI which surged to 60.80 in February. With the economy so strong, we expect the US 10-year yield to drift higher, reaching somewhere between 3 and 3.5%, before year-end. However, what is key is that this ascension is expected to be smooth, allowing for a continuation of equity market strength. A sudden spurt could derail markets.
After the Eurozone recorded GDP growth of 2.7% in 2017 (the fastest pace in a decade), economic momentum has paused for breath, but this has not affected our positive growth outlook. Thus far in 2018, inflation has dipped to 1.2% but the ECB forecasts that it will tick upwards from here on out. However, it is not expected to reach the 2% target until beyond 2020.
In response to resounding economic strength, central banks are rolling up their sleeves with regards to reducing monetary stimulus. Incoming Fed Chairman Jerome Powell’s somewhat hawkish congressional testimony, coupled with continued economic strength, has led the market to add an additional hike to its expectations for 2018. In total, the market consensus is for three hikes, with a fourth now seen as decidedly more probable. Inflation, on the whole, still remains low. Headline PCE inflation (the Fed’s preferred measure) is at 1.7%, lifted by the housing sector. This indicates that US economic conditions are still running closer to “just right” than “too hot”, for now.
To avoid falling behind the curve, the Fed is seeking to raise rates, albeit gradually, so as to keep the economy from overheating without impeding economic expansion. If the Fed stays consistent in its actions and focuses on the macro picture, we don’t see any reason to fear higher rates. The danger comes when markets anticipate that the Fed will hike too aggressively.
Elsewhere, at its March policy meeting, the ECB began to rotate its forward guidance, dropping its pledge to increase its bond-buying if needed. The German Bund, which was 0.7% at the time of print, is expected to yield 0.9% before year-end. That being said, the market expects that it will be more than a year before the ECB hikes rates. In Japan, the government confirmed Kuroda as the Bank of Japan Governor for a further five years. He has said that the bank would consider an exit from its ultra-easy monetary policy if it met its inflation target in 2020.
Equities
Even if concerns over Fed policy and tighter financial conditions have dominated markets in the short-term, economic activity and earnings data continue to evidence above-trend growth. Earnings are one of the most powerful drivers of stock market performance over time and the corporate earnings picture continues to be quite healthy. We do expect higher volatility as the Fed goes ahead with its hiking cycle, but maintain an equity overweight as we do not see any specific signs of complacency. In the US, we favour cyclical sectors such as IT and Financials. We also favour select Energy names, as the sector’s performance has lagged the increase in oil price.
As well as cyclical sectors, we also maintain exposure to cyclical regions, namely Europe. While the temporary respite in economic momentum is likely to bring difficulties for equities in the shortterm, over a longer timeframe the reflation theme is supportive of a European tilt; Europe has historically been a key beneficiary of rising US yields. In particular, we are overweight on European Financials who should see their bottom lines improve in tandem with rising rates.
Emerging Markets (EM) continue to benefit from the global growth story, but we are monitoring the developments surrounding US import tariffs and any retaliation. At the moment, it seems that the risk of a global trade war is contained, but EMs would take a hit if this was to materialise.
Fixed Income
Bond markets offer few places to run to, and even fewer places to hide.
In 2018, we expect to see a dramatic increase in US bond supply as the government seeks to finance its budget deficit. At the same time, the Fed will be reducing its holdings. Unless floods of new buyers emerge, long rates will move higher and credit spreads will widen.
Rising rates are detrimental to fixed income, making us even more reluctant on this asset class. Expectations for a rise in rates compel us to lower our overall duration by reducing some of our exposure to Emerging Market hard currency debt.
When stronger-than-expected US wage data pushed up US yields at the beginning of February, yields on hard currency EM bonds went up hand-in-hand with them, and prices fell. In light of further yield increases on the horizon, the attractiveness of this segment comes under pressure.
We are maintaining local currency EM debt positions as this asset class is not driven by US rates and thus provides some diversification, while supportive fundamentals paint this segment as an interesting investment case on its own. These instruments are currently yielding around 6%.
With regards to our investment grade holdings, we also intend to use any temporary decrease in rates as an opportunity to rebalance in a way that reduces duration.
Inevitably, rates are headed north. As long as this happens gradually, we do not see any reason for investors to get spooked. In fact, with a nuanced portfolio of asset classes which benefit from rising rates – for example cyclical equities - investors can position themselves to benefit from the final leg of the cycle which has typically brought quite handsome returns.
Download the pdf version here (in French)
Disclaimer
All financial data and/or economic information released by this Publication (the “Publication”); (the “Data” or the “Financial data
and/or economic information”), are provided for information purposes only,
without warranty of any kind, including without limitation the warranties of merchantability, fitness for a particular
purpose or warranties and non-infringement of any patent, intellectual property or proprietary rights of any party, and
are not intended for trading purposes. Banque Internationale à Luxembourg SA (the “Bank”) does not guarantee expressly or
impliedly, the sequence, accuracy, adequacy, legality, completeness, reliability, usefulness or timeless of any Data.
All Financial data and/or economic information provided may be delayed or may contain errors or be incomplete.
This disclaimer applies to both isolated and aggregate uses of the Data. All Data is provided on an “as is” basis. None of
the Financial data and/or economic information contained on this Publication constitutes a solicitation, offer, opinion, or
recommendation, a guarantee of results, nor a solicitation by the Bank of an offer to buy or sell any security, products and
services mentioned into it or to make investments. Moreover, none of the Financial data and/or economic information contained on
this Publication provides legal, tax accounting, financial or investment advice or services regarding the profitability or
suitability of any security or investment. This Publication has not been prepared with the aim to take an investor’s particular investment objectives,
financial position or needs into account. It is up to the investor himself to consider whether the Data contained herein this
Publication is appropriate to his needs, financial position and objectives or to seek professional independent advice before making
an investment decision based upon the Data. No investment decision whatsoever may result from solely reading this document. In order
to read and understand the Financial data and/or economic information included in this document, you will need to have knowledge and
experience of financial markets. If this is not the case, please contact your relationship manager. This Publication is prepared by
the Bank and is based on data available to the public and upon information from sources believed to be reliable and accurate, taken from
stock exchanges and third parties. The Bank, including its parent,- subsidiary or affiliate entities, agents, directors, officers,
employees, representatives or suppliers, shall not, directly or indirectly, be liable, in any way, for any: inaccuracies or errors
in or omissions from the Financial data and/or economic information, including but not limited to financial data regardless of the
cause of such or for any investment decision made, action taken, or action not taken of whatever nature in reliance upon any Data
provided herein, nor for any loss or damage, direct or indirect, special or consequential, arising from any use of this Publication
or of its content. This Publication is only valid at the moment of its editing, unless otherwise specified. All Financial data and/or
economic information contained herein can also quickly become out-of- date. All Data is subject to change without notice and may not be
incorporated in any new version of this Publication. The Bank has no obligation to update this Publication upon the availability of new data,
the occurrence of new events and/or other evolutions. Before making an investment decision, the investor must read carefully the terms and
conditions of the documentation relating to the specific products or services. Past performance is no guarantee of future performance.
Products or services described in this Publication may not be available in all countries and may be subject to restrictions in some persons
or in some countries. No part of this Publication may be reproduced, distributed, modified, linked to or used for any public or commercial
purpose without the prior written consent of the Bank. In any case, all Financial data and/or economic information provided on this Publication
are not intended for use by, or distribution to, any person or entity in any jurisdiction or country where such use or distribution would be
contrary to law and/or regulation. If you have obtained this Publication from a source other than the Bank website, be aware that electronic
documentation can be altered subsequent to original distribution.
As economic conditions are subject to change, the information and opinions presented in this outlook are current only as of the date
indicated in the matrix or the publication date. This publication is based on data available to the public and upon information that is
considered as reliable. Even if particular attention has been paid to its content, no guarantee, warranty or representation is given to the
accuracy or completeness thereof. Banque Internationale à Luxembourg cannot be held liable or responsible with respect to the information
expressed herein. This document has been prepared only for information purposes and does not constitute an offer or invitation to make investments.
It is up to investors themselves to consider whether the information contained herein is appropriate to their needs and objectives or to seek advice
before making an investment decision based upon this information. Banque Internationale à Luxembourg accepts no liability whatsoever for any investment
decisions of whatever nature by the user of this publication, which are in any way based on this publication, nor for any loss or damage arising
from any use of this publication or its content. This publication, prepared by Banque Internationale à Luxembourg (BIL), may not be copied or
duplicated in any form whatsoever or redistributed without the prior written consent of BIL 69, route d’Esch ı L-2953 Luxembourg ı
RCS Luxembourg B-6307 ı Tel. +352 4590 6699 ı www.bil.com.
Read more
More
January 10, 2025
NewsVideo summary of our Outlook 2025
2024 - The US economy exhibited impressive strength powered by consumption, while Europe struggled with weak demand and a protracted manufacturing downturn 2025 - The...
December 27, 2024
NewsBIL Investment Outlook 2025 – T...
Introduction from our Group Chief Investment Officer, Lionel De Broux As the oldest private bank in Luxembourg, we’ve been managing clients’...
December 20, 2024
Weekly InsightsWeekly Investment Insights
Having spent ten straight days decked out in red, the Dow Jones Industrial Average index recorded is longest losing streak since 1974. Other global...
December 13, 2024
Weekly InsightsWeekly Investment Insights
It has been a big week for France, with Notre Dame finally reopening after five years of reconstruction, and Francois Bayrou being named France’s...
December 9, 2024
Weekly InsightsWeekly Investment Insights
December is here, and while the cold, dark days may not be everyone's cup of cocoa, the festive spirit is starting to set in....