With the US Federal Reserve poised to begin raising interest rates for the first time in nearly a decade, the timing of ‘lift-off’ is the subject of intense scrutiny, writes Lazard Asset Management's Ron Temple.
While the first rate hike could happen this year, the subsequent trajectory of rate hikes will be much more important, in our view, than the timing of the first one.
In our opinion there may be benefits for the Federal Open Market Committee (FOMC) to wait until 2016 because a substantial excess supply of labour still remains.
Our latest estimate is that the US needs to create between 2.2 and 4.8 million jobs to absorb this slack, a process that could take anywhere from 13 to 24 months, assuming the creation of 225,000 to 275,000 jobs per month.
Nevertheless, a number of recent speeches by voting FOMC members indicate that ‘lift-off’ may well occur in 2015.
It is important to point out that raising rates by 25 basis points (bps) or even 50 bps is not likely, in our view, to substantially affect the growth rate of the US economy or the pace of labour market healing.
In our view, we think there are three scenarios for lift-off, the pace of rate increases, and how high rates might go in this tightening cycle.
The Base case is that increases take place at the December 2015 FOMC meeting and the rate target range reaches a two per cent upper bound by mid-2017.
We think this is the most likely scenario at the present time. It means economic growth will likely remain uninspiring, with real GDP growing about two per cent per annum.
The investment implications could include a ‘permanently’ lower discount rate, which could lead to higher valuations, but the implied weakness of the recovery could lead to lower revenue growth expectations.
These factors could create a ‘barbell’, with growth stocks achieving even higher valuations and high-dividend-yield stocks also rising in value.
It may result in more highly leveraged companies underperforming in recognition that the ‘free money’ era is over, though the impact would be limited by the still-low level of rates.
The more Hawkish case is that ‘lift-off’ takes place earlier, at the September 2015 FOMC meeting and that the rate target range reaches a three per cent upper bound by mid-2017.
In this scenario, equity markets could face some downside risk as investors question the appropriate discount rate for future cash flows.
This could be somewhat balanced by a stronger economic outlook, especially if momentum builds in consumption and housing.
Active managers have the possibility to benefit as winners from the period of exceptionally low rates become the relative losers in an environment of increasing rates.
Finally, the Dovish case is that ‘lift-off’ takes place later, at the March 2016 FOMC meeting and the rate target range reaches a 1.25 per cent upper bound by mid-2017.
We believe this scenario is least likely but could result in equity markets benefiting as investors reassess future discount rates and realize that stocks trading at a forward P/E ratio of 16–18 times, often with dividend yields well above sovereign debt yields, are a relative bargain.
These scenarios all imply that rates will remain extraordinarily low by historical standards.
It is important to note that there is no parallel in US history for the current monetary policy.
Hence, we do not find it instructive to look back to previous tightening cycles or inflationary episodes.
We also note that these scenarios are to the dovish side of FOMC median projections and roughly in line with futures markets.
In all three scenarios, we would expect the US economy to continue growing at a relatively moderate pace with varying degrees of labour market improvement.
Two of the three scenarios are also seen as relatively benign for investors in equities and fixed income.
It is only in our more ‘hawkish’ scenario that we see more volatility arising as the market is currently pricing a path that is meaningfully different from this case.
Regardless of which scenario ultimately unfolds, we continue to focus our bottom-up research on identifying securities that we expect to outperform based on their company-specific drivers.
We continue to believe that the best investments are in shares of companies that have strong balance sheets, robust organic cash-flow growth, and the operational flexibility that arises from these characteristics, thus allowing a company to navigate the twists and turns of monetary policy.
Ron Temple is a global equity portfolio manage/analyst and co-director of research at Lazard Asset Management.