Any fudge from the Fed will only create further indigestion

As wiser heads than this column have frequently pointed out, if money printing solved economic problems Zimbabwe would be the richest country in the world and if centrally-planned economies were a good idea, the USSR would still exist and China would not be embracing capitalism to any degree whatsoever.

However, the world’s central bankers appear to think differently so this column must yet again discuss their thoughts and policies, frustrating as this is – all advisers and clients can do is deal with the circumstances which face them and right now markets are in thrall to a select number of unelected public officials, upon whose every word they hang.

The European Central Bank and the Bank of England have already had their say and on 16 December it will be the US Federal Reserve’s turn. At 19:00 UK time, chair Janet Yellen will announce whether the American central bank has sanctioned the first increase in US interest rates since 2006 (or not, as the case may be).

Following two strong non-farm payrolls reports, the market appears convinced that a rate rise is finally upon us. The manner in which stocks and bonds wobbled when the Fed ducked this decision in September may also persuade Yellen she has done the groundwork and prepared advisers and clients for that first tightening move.

For the moment, US markets seem content to believe America’s economy is strong enough to withstand a rate rise.

If this proves to be the case, US stocks may still do well in 2016, as growth is hard to find and American assets could attract cash on the basis its economy is doing better (or less badly) than others. History also shows that the US market does worst, on average, going into and coming out of a first rate rise in a new cycle. The graphic below shows how the S&P 500 has done on average before and after the first rate increase in the past seven cycles going back to 1971.

Uncertainty means S&P 500 tends to do worst going into and coming out of a first rate rise, on average

Source: Thomson Reuters Datastream

So long as the economy keeps firing and company profits keep growing, US stocks do seem to gather their nerve – although those preconditions are important.

The prospect of a rise in the dollar may also lure in UK-based advisers and clients, as a potential extra bonus. Anyone buying into this scenario is spoiled for choice when it comes to picking a fund, actively or passively run, with which to access the market.

Best performing US Large-Cap Blend Equity OEICs over the past five years

Source: Morningstar, for US Large-Cap Blend Equity category.
Where more than one class of fund features only the best performer is listed.

Best performing North American investment trusts over the past five years

Source: Morningstar and the AIC, for North America and North American Smaller Companies Categories. * Includes performance fee

Best performing US Large-Cap Blend Equity ETFs over the past five years

Source: Morningstar, for US Large-Cap Blend Equity category. Physical ETFs only.
Where more than one class of fund features only the best performer is listed.

Range of options

When the Federal Open Markets Committee meets on 15-16 December it has three options:

  • It can decide to do nothing, but this may raise some serious questions about the Federal Reserve’s credibility and possibly stoke fears the US central bank is acting too slowly, leading to inflation later on
  • It could go for the standard one-quarter point rate hike
  • It could try to finesse the situation and go for a one-eighth of a point hike

There is then also the issue of what guidance Janet Yellen gives, if any, for 2016 on whether the Fed will go for further hikes (assuming there is one) or not. Next year will see a US Presidential election and any and every move will be hotly debated in Washington, even if the Fed is politically neutral.

If forced to guess, this column is looking for a “one and done” as some are terming it – a quarter-point hike and then no action in 2016 (despite lots of talk about doing something).

Whether that’s enough to keep the US equity pot boiling will depend on whether the economy holds up and corporate earnings reaccelerate after what has been a tough 2015.

This chart comes from research by Standard & Poor’s and is based on bottom-up earnings per share (EPS) estimates for America’s S&P 500 index. Earnings have fallen year-on-year in each of the first three quarters of 2015, so analysts had better be right that a big rebound is coming, especially if the Fed does raise rates, as the going could get choppy if company profits keep sliding.

US earnings need to bounce back to keep markets on a steady upward trend

Source: Standard & Poor’s research, US analyst consensus

Mixed messages

It is unlikely the Fed will strike too strident a tone as the economic picture in the US is far from clear-cut, as the above chart of corporate profits suggest.

Yes, the non-farm payrolls have been good and unemployment has come rattling down, but jobs data are lagging indicators. It takes time for a firm to feel confident and profitable enough to hire and then go through the process of finding the right people.

US unemployment is falling but this is a lagging indicator


Concurrent indicators like industrial production, retail sales and durable goods orders offer a murkier picture, as the year-on-year growth trends for all three in this graphic illustrate:

Concurrent indicators such as retail sales, durable goods order and industrial production remain mixed

Source: Thomson Reuters Datastream,

Lead indicators like manufacturing sentiment surveys look gloomier still. This chart looks at the trend in new orders from the Richmond, Philadelphia, Dallas, Kansas and New York Federal Reserve surveys.

Lead indicators like new orders in sentiment surveys are still weak

Source: Thomson Reuters Datastream

Even allowing for some tentative improvement this autumn they hardly smack of an economy firing on all cylinders.

Hot flows

The Fed may raise rates all the same, simply because not doing so would do more damage to its credibility, if September’s downward lurch in markets is any guide – and frankly if it cannot tighten monetary policy after seven years of ultra-loose rates and a $3 trillion-plus expansion of the Fed’s balance sheet, we really are in a pickle and the S&P 500 shouldn’t be anywhere near the 2,000 level anyway.

The removal of some uncertainty could also help sentiment, especially if advisers and clients get a firm steer on policy for 2016 (although this seems unlikely to this column).

Equally, the lesson of the last five years has been to follow the money. The US roared ahead when the Fed was running its QE scheme and the same could be said for the UK. Both equity markets have found the going tougher since the Bank of England and the Fed stopped adding to their programmes in 2012 and 2014 respectively.

Since then, Japan and Europe have taken the lead, generating superior total equity market returns (in local currency terms, at least), buoyed by QE schemes launched in April 2013 and March 2015.

Japan’s QE scheme continues to drag the Tokyo market higher

Source: Bank of Japan, St. Louis Federal Reserve database, Thomson Reuters Datastream

Europe’s QE scheme is also boosting the Stoxx Europe 600 index

Source: European Central Bank, Thomson Reuters Datastream

The Bank of Japan’s ¥6.7 trillion-a-month (£36.3 billion) scheme has no time limit, whereas the Eurozone’s €92 billion-a-month (£66.7 billion) plan is due to run until March 2017 (though it requires little imagination to see ECB President Mario Draghi providing a further extension to that deadline).

With America possibly on the road to tightening, recent history would suggest US stocks are due a stickier patch, or at least a period of lagging Japan and Europe – although that of course assumes that investors and clients believe central banks’ ability to influence markets does not go the way of the Zimbabwean and Soviet economies.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.