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What is going to happen to markets when interest rates rise?

01 December 2015

Trevor Greetham, head of multi-asset at Royal London Asset Management, explains the potential implications from an interest rate rise from the Federal Reserve, and outlines three scenarios that could play out in the New Year.

By Lauren Mason,

Reporter, FE Trustnet

The impending interest rate hike from the Federal Reserve remains one of the most important themes going into the New Year, according to Trevor Greetham (pictured).

The head of multi-asset at Royal London, who also runs the group’s Cautious Managed fund, says that there doesn’t seem to be a lot of pressure to hike rates at first glance, but the Fed is unusually late to get started due to current US unemployment levels.

According to data obtained by the asset management firm, US unemployment has halved over the last five years, shrinking to just 5 per cent. The Congressional Budget Office’s (CBO) Estimate of Nonaccelerating Inflation Rate of Unemployment (NAIRU) is also now at 5 per cent, which suggests that inflation should have already started picking up by now as shown in the below graph.

Performance of Fed funds and US Unemployment rate over 20yrs

Source: Thomson Reuters Datastream

This unusual phenomenon, combined with the fact that the last rate cycle was more than a decade ago, means investors need to keep an eye on the rate hikes, which are expected to be announced this month, according to the manager.

“We’ve got to the point where inflation is meant to start rising and it hasn’t even got off the blocks. Normally by now the US Fed funds target rate would be neutral which equates to inflation plus about two historically, so 3 or 4 per cent, but currently it’s at zero,” he explained.

“A lot of people in the Fed are thinking, ‘I know that the manufacturing cycle is at a low ebb and inflation is low but we’ve got to get started and if we leave it too late to start we will have to raise rates very rapidly’.”

“Most people out there are saying that terminal rates on Fed funds won’t be as high as 3 or 4 per cent anyway, but I’m quite sceptical about that.”

Greetham believes that, as the Fed raises interest rates and the global economy demonstrates it can cope, it will keep hiking and rates could end up far higher than people are expecting them to be.

“The old hands among us who have seen Fed rate cycles before know that every time there’s a rate hiking cycle, it carries on raising interest rates until something snaps,” he warned.

“In 2000 it was the Dotcoms and in the 1990s it was Mexico [the 1994 Peso crisis], we have been littered with financial institutions going belly up during Fed tightening. It’s something to take very seriously, although we think it’s going to be a long and gradual type of cycle.”

The manager and his team believe that there are three potential situations than could occur as a result of rate rises.

The first and most bearish scenario would be an immediate relapse into recession, although Greetham discounts this.


The team’s base case is that the Fed will hike alone, which will keep the dollar strong and therefore benefit developed market equities.

However, he believes the most likely alternative is that there will be a synchronised inflationary upturn, which will benefit both commodities and emerging markets as bond markets sell off.

As a result, he is considering increasing his emerging markets position from underweight to neutral in the New Year.

“The people who would argue in favour of the worst case scenario would say that money printing worked through smoke and mirrors, and that as soon as you raise interest rates, the financial crisis will come back,” he said.

“We don’t believe that’s the story because while we think there are losers from falling commodity prices, there are also winners. Every time the oil price falls you get all the bad news from BP and Shell and emerging markets but the good news is that people have got more money to spend.”

Greetham adds that investors should only be worried about the Fed hiking rates if they think it is trying to increase unemployment to stop the economy from growing so strongly, but he believes that people shouldn’t fear a normalising Fed.

Because he thinks that the Fed is simply “tapping on the breaks”, he thinks that stock markets should continue to do well, and that if global inflation occurs, there is an even stronger strong bull argument to invest in equities in 2016.

According to data acquired by Royal London, there is also huge upside potential in Europe when looking at money supply levels in the eurozone as an indicator of GDP growth.

When looking at data on a 12-month lag, monetary supply in the region rocketed in 2014 and will be boosted even further as a result of Europe’s ultra-loose monetary policy this year.

As such, Greetham expects GDP in the eurozone to accelerate rapidly in the near future.

Euro area money supply growth vs GDP in Europe over 20yrs

Source: Thomson Reuters Datastream

“There’s been a big drop in commodity prices and we think there is a future of strong consumer spending, and we’ve also seen this very strong upside potential in Europe,” he said.


“The data is suggesting there could be a really big acceleration in GDP growth, and in some ways I think the ECB is about to put fuel in the fire. I think there’s going to be quite a strong upturn in Europe next year anyway, and with the weak euro and the actual stimulus I think it could be surprisingly strong.”

The manager adds that Chinese data hasn’t been as torrid as the media has portrayed it to be, and that while China’s growth is indeed slowing, the country is cutting interest rates and making it easier for banks to lend money, and is devaluing its currency.

 “China has started to press all the buttons try to get the economy at least to stabilise and maybe pick up,” the manager added.

“There’s a possibility that what we’ll see next year is the US consumer accelerating, Europe accelerating, China at least stabilising and then if that happens manufacturing will pick up as well.

In that environment, you’ll get much more inflationary upturn which will make equities the desirable asset class.”

Since Greetham launched the Royal London Cautious Managed fund in June this year, it has lost 0.02 per cent, outperforming its peer average in the IA Mixed Investment 20%-60% Shares sector by 0.64 percentage points.

Performance of fund vs sector since launch

Source: FE Analytics

Since 2006, the manager has also outperformed his peer group composite by 17.93 percentage points, providing a total return of 64.23 per cent.

Royal London Cautious Managed has a clean ongoing charges figure of 0.67 per cent.

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