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Abu Dhabi, UAESaturday 15 December 2018

Will higher US interest rates and the stronger dollar destroy the stock market?  

The Federal Reserve and other central banks are applying the brakes to years of rising growth and accelerating asset prices

Illustration by Alvaro Sanmarti
Illustration by Alvaro Sanmarti

An old stock market saying has swung back into favour, and if it still holds true then investors need to sit up and listen.

Bull markets do not die of old age, the adage goes, but are killed off by the US Federal Reserve.

This saying has been dusted down because it looks like one of the longest bull markets in history is on its last legs and investors are waiting to see what finally kills it off. The Fed is the most likely culprit, although US President Donald Trump may also have his finger on the trigger.

So why would the US central bank want to kill bull markets just when everybody is enjoying themselves?

Inflation is the main reason. Years of rising growth and asset prices accelerate as people and businesses became more profligate with their borrowing and spending, leading the economy to overheat and inflation to run rampant.

The Fed and other central bankers are forced to apply the brakes before things get really out of hand.

Most bull markets since the war have been finished off by the Fed withdrawing monetary stimulus and now it is at it again, hiking lending rates seven times in three years to a range of between 1.75 per cent to 2 per cent.

The bull market has been raging since March 2009, when central bankers slashed interest rates to near zero and launched quantitative easing to save the global economy from meltdown.

By the end of June it had run for 3,401 days and is closing on the post-war record of 3,452 days, which ran between October 1990 and March 2000. It could overtake that record in less than 50 days.

Russ Mould, investment director at AJ Bell, who compiled these figures, says the US is still in party mode. “Buoyed by President Trump’s tax cuts, its economy is going gangbusters, with the Atlanta Fed GDP Now survey forecasting an annualised growth rate of 4.7 per cent for the second quarter.”

Since the US is the world's biggest economy this should continue to drive a global recovery. “Inflation also remains tame, undershooting central banker targets of 2 per cent in Japan and Europe, and only marginally exceeding this in the US and UK,” he says.

Mr Mould says the slow recovery in savings rates and bond yields means investors will continue to favour stock markets, supporting share prices for now.

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However, there are signs of a slowdown he says, with the MSCI World Index falling 0.8 per cent since the start of the year. “Asia and Western Europe have struggled and Latin America has taken a clobbering."

The US market looks overvalued by traditional metrics, currently standing at 32.30 on the Shiller index, double its median average valuation of 16.15 times company earnings. “US stocks have only been this expensive in 1929, 2000 and 2007, and disaster followed each time," says Mr Mould.

The Fed isn't the only one tightening, the European Central Bank is looking to stop its quantitative easing programme, while the Bank of England is considering a rate hike in August, although Brexit may postpone that again. “Share prices may therefore have less cheap money upon which to feed,” Mr Mould says.

Markets are doing their best to ignore geopolitical concerns such as Brexit, the rise of anti-EU parties in Italy, global indebtedness, the strong dollar, rising oil price and the prospect of a global trade war, as the European Union and China announce tit-for-tat tariffs against the United States.

Mr Mould says merger and acquisition and buyback activity are near record levels but warns: “They tend to occur near the top of stock market cycles, when animal spirits are running.”

Vijay Valecha, chief market analyst at Century Financial Brokers in Dubai, says history suggests stock markets can withstand higher interest rates, noting that during the bull markets of the late 1980s and 1990s interest rates ranged between 3 per cent and 9.75 per cent, with an average of 5.9 per cent.

“The Federal Reserve prefers to keep its funds rate between 2 per cent and 5 per cent, which keeps GDP growth in check and prevents bubbles," he says. "Another four quarter point hikes would only lift them to 3 per cent, which is hardly a threat.”

Mr Valecha remains optimistic overall. "If we do get further volatility, safe havens are likely to be US Treasuries and the Japanese yen. However, I do not see the bull market coming to an end for some time.”

Peter Garnry, head of equity strategy at Saxo Bank, points to the growing concern that Fed monetary tightening will further drive up the value of the dollar, hitting emerging market countries that have issued a vast pile of sovereign and corporate debt in US dollars since the financial crisis.

The stronger dollar will push up the cost of these debts when converted into emerging markets' home currencies, Mr Garnry says. “The governor of the Reserve Bank of India recently warned that a dollar liquidity crisis could become a theme in 2019.”

He says the benefits of Trump’s corporate tax cuts should offset rising interest rates for now, but warned that global stock markets are now entering their final expansion phase: “Global equities will top out in six to nine months.”

Mr Garnry is less concerned about the trade war, remaining optimistic that the US will make peace. “There are only losers in a trade war and everybody knows it."

However, there could be collateral damage along the way. “The first phase is focusing on car companies, so we are recommending clients to be underweight in this sector. The US agricultural sector is also a casualty. The semiconductor industry could be vulnerable, as it has a convoluted supply chain spanning the US, China and other Asian countries,” Mr Garnry adds.

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Fiona Cincotta, senior market analyst at City Index, says risk aversion is kicking in as Mr Trump’s trade tariff spat escalates, with the Shanghai composite, European bourses and US markets all suffering losses. “Safe haven currencies such as the Japanese yen and Swiss Franc are seeing increased inflows.”

A full-blown war could knock 2 per cent to 3 per cent off global GDP, Ms Cincotta says. “The financial crisis and great recession wiped out 6 per cent, so this is by no means insignificant.”

For weeks the market has viewed Mr Trump’s tough protectionist rhetoric as a negotiating tool, now investors fear that he really might follow through on his threats. “Risk is being taken off the table with equities taking a hit,” Ms Cincotta says.

A drop in Chinese exports would hit the nation’s voracious demand for commodities such as energy, metals and minerals, while individual tariffs will hurt targeted sectors and their supply chains. “The prospect of a downward spiral is very real,” Ms Cincotta says.

She says investors often use market falls as a chance to buy the dips but it is difficult to view current market weakness as a buying opportunity: “The second half of the year, including the unpredictable summer months, may prove even more volatile.”

Rebecca O’Keeffe, head of investment at online trading website Interactive Investor, says the Chinese authorities are taking drastic action to protect the domestic economy. “The People’s Bank of China has cut its required reserve ratio for banks, freeing up money that the banks can lend to stimulate the market. Policymakers stand ready to step in should the situation deteriorate any further.”

Steven Downey, chartered financial analyst candidate at Holborn Assets in Dubai, says a recession is inevitable after such a long spell of growth and it will hurt. "It will most likely be accompanied by a stock market crash, possibly up to 30 per cent."

Almost every other asset class will also suffer, including property. "Only gold and precious metals are likely to be immune,” he says.

Chris Beauchamp, chief market analyst at IG, a global leader in online trading with offices in Dubai, says investors should not give up on shares yet. “This is still a bull market, and dip-buying makes sense given the strong global outlook.”

Luca Paolini, chief strategist of fund manager Pictet Asset Management, fears a full-scale trade war would tip the global economy into stagflation. “When trade breaks down, everybody loses. Erecting trade barriers is bad for equity markets.”

He notes that US president Richard Nixon imposed a 10 per cent tariff on imports in 1971, and the S&P 500 fell 10 per cent in the following three months. “As IMF chief Christine Lagarde rightly observed, nobody wins a trade war.”

Mr Paolini says the impact will be felt far beyond the two world's largest two economies: “Open economies such as Taiwan, Korea and Singapore in Asia and Hungary, the Czech Republic and Ireland could be more vulnerable than the US and China.”

Tom Stevenson, investment director for personal investing at global fund manager Fidelity International, says dollar strength will hit emerging markets. “With this in mind, it may be good time to increase exposure to defensive US companies," he says. "For those wanting a mutual fund my choice would be the Old Mutual North America, which includes well-known defensive names such as oil giant Exxon Mobil.”

Another option could be the Rathbone Global Opportunities Fund, which has more than half of its portfolio allocated to US companies.

The bull market has to end one day – they always do – and that day is moving closer. The bears may have to be patient for a little while longer, though.

Jane Sydenham, investment director at Rathbones, says after nearly a decade of growth the economic cycle is getting tired. “Trade wars are just another worry on top of other existing global economic problems, but the expectation of recession is usually necessary for a bear market and we don't believe that is about to happen," she says. "Investors should not be too worried yet, but should brace themselves for more volatility."