US rate hike – the biggest non-surprise of 2016?

The US Federal Reserve’s decision to hike the federal funds target rate from 0.25-0.50% to 0.50-0.75% on Wednesday can hardly be described as a surprise. Already after the US presidential election results, amid a sell-off in US Treasuries, markets were pricing in a near-certain increase in the US Federal Reserve’s federal funds target rate by early December.

Still, this interest rate hike is only the second of this decade and occurred much later than participants of the US Federal Open Market Committee (FOMC) expected two years ago. In December 2014, most members of the FOMC thought the federal funds target rate would be 2% or higher at end 2016. This has not been the case, partly because of uncertainty in international markets created by events such as Brexit and because US growth has not picked up as much as anticipated, while inflation has remained subdued – up to now.

US policy is paving the way for inflation

President elect Trump’s fiscal plans imply a sustained regression in the federal budget and a rising federal debt ratio, unless the US can achieve and sustain real GDP growth of more than 3%, driven by proposed increased infrastructure spending (amid expenditure cuts elsewhere) and tax cuts. However, the scale of Trump’s proposed fiscal policy may not be realistic. Trump’s fiscal and trade policy proposals could ultimately pave the way for higher inflation and market participants are cognisant of this. Since the election bond markets have sold off, although apparently not due to a marked increase in inflation expectations. US 10-year government bond yields spiked from 1.83% to 2.38% during the month of November.

US unemployment is at a nine-year low

Other than growth and productivity (soft productivity threatens higher inflation down the line), the US unemployment rate (low unemployment levels could push up wage increases) is another major factor the FOMC would have considered in its decision. US unemployment has recently hit a 9-year low at 4.6%. Unemployment has been at or below 5% for nearly a year now, historically a positive signal for the FOMC to raise rates. Although the annual advance in non-farm payrolls has slowed significantly since 2014/15 it has been relatively stable at close to 1.7% since May 2016.

The impact of rising interest rates on your portfolio

For now, until we have greater clarity on likely changes to fiscal policy, we expect the FOMC to stick with its long-standing communication, which suggests gradual increases in the federal funds rate. Note, the median of the FOMC participants’ “assessment of appropriate monetary policy” now shows an additional interest rate increase in the federal funds target rate for next year. That means three hikes rather than two currently seems appropriate to the FOMC, which would leave the rate at 1.25-1.5% at end 2017, if realised.

What does a rising rate hike cycle mean for your portfolio as an SA investor?

Not only the SA Reserve Bank, but central banks around the world, especially those in emerging market economies running macroeconomic imbalances, are paying careful attention to the Fed’s tempo of raising interest rates. If the Fed becomes more aggressive than anticipated this could accelerate the depreciation of the rand, with the knock-on effect of higher local inflation as import prices rise.

If the depreciation of the rand does indeed lead to higher inflation, this will put upward pressure on SA interest rates. Higher interest rates translate to better nominal returns on cash, but these returns, depending on the individual’s specific consumer basket, may not keep up with the individual’s experience of inflation.

In terms of the bond component of your portfolio, Mokgatla Madisha, head of Fixed Interest at Sanlam Investment Management, views the rise in US – and therefore global – bond yields as having a significant impact on emerging market (EM) and SA yields. The latest survey from Morgan Stanley shows that US-based EM investors are already quite underweight South Africa. At current bond yields of around 9% Madisha thinks investors should focus on the potential for bonds to deliver positive real returns over the next 6 to 12 months.

As far as your share portfolio is concerned, rand hedge and dual listed shares should be mostly insulated from the potential currency weakness resulting from higher US interest rates, while rand leverage shares (companies with a foreign earnings base and local cost base) may even benefit. The locally orientated companies and those in interest rate sensitive sectors such as some retailers, industrials and financials will be most vulnerable to a rising interest rate cycle. Lastly, SA listed property is also vulnerable, given the sensitivity of this sector to interest rates and an increase in bond yields.