Fed rate tightening could be positive for equity ETF returns, says Source

Dec 16th, 2015 | By | Category: ETF and Index News

Recent economic data makes the decision of the Federal Open Market Committee (FOC) on 16 December less clear-cut than the market seems to think, according to Source, a leading European exchange-traded fund provider.

Fed rate tightening could be positive for equity ETF returns, says Source

Bloomberg estimates suggest a market-based probability of around 80% for an interest rate hike at the US Fed’s December meeting.

In particular, the disappointing results of the most recent ISM Manufacturing survey would normally point to the need to loosen monetary policy, as opposed to the market’s current expectations of rate tightening. Bloomberg estimates suggest a market-based probability of around 80% for an interest rate hike at the December meeting.

In his weekly note to investors, Paul Jackson, Head of Multi-Asset Research at Source, said that, despite the dip in ISM Manufacturing data, he still believes the Fed will raise interest rates, most likely by 0.25%. Assuming that the ISM Manufacturing survey is giving a false signal (other sectors of the economy are doing better), he believes the Fed will follow up with a further three rate hikes of 0.25% each during 2016.

A review by Source of USD-denominated average annualised total returns during previous Fed tightening cycles shows that a broad range of asset classes have exhibited positive performance – for instance, global equities have returned, on average, around 10% per annum, emerging market equities 12% and commodities 18%. According to Source, investors typically see Fed tightening as a positive reflection of the strength of the US-led recovery.

Jackson added: “Our research shows that since the mid-1930s there were only two periods of monetary tightening out of 16 during which investors lost money on the S&P 500. It is important, therefore, to counter misperceptions that a rate hike is necessarily bad news for markets, including the belief that volatility tends to increase during such cycles. Our analysis shows that market returns during such periods of tightening have been positive and with lower volatility across a variety of asset classes and indices.”

Source suggests the weakness of the manufacturing sector has to be a concern at a time when Fed policy remains extremely loose (he notes that the Fed has held rates at current historical lows since 2008 and that taking account of the effects of Quantitative Easing (QE) implies the Fed’s overall policy stance is the equivalent of -5% interest rates). At best, the Fed will be limited in the speed with which it can raise rates. At worst, it may have to reverse the hikes pretty quickly and then be faced with a problem about what to do next to revive the economy.

By way of comparison, the previous six Fed tightening cycles lasted an average of 13.7 months and the average rate hike was 2.81% (0.21% per month). Source believes that the forthcoming cycle may be slower and longer given the relatively larger headwinds, and is forecasting 0.25% per quarter over multiple years depending on the rate of inflation.

Given Source’s analysis of historical asset class performance investors could increase allocations to global equities and emerging market equities as well as commodities. This can be implemented through a range of ETFs. For global developed markets equity exposure investors could look to ETFs which track indices such the MSCI World Index. These are available from a range of issuers including iShares, Lyxor, Source and db x-trackers. These providers also offer broad emerging market equity ETFs. Commodity exposure can be implemented through ETFs from the same issuers as well as from ETF Securities and Boost ETP.

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