US investors face unpalatable combination: rising rates and a slowing economy

It’s been a tough road for the US share market since the Dow Jones Industrial Average climbed to a record high at the beginning of the month. Since reaching that milestone on October 3, the blue-chip DJIA has shed 5.6 per cent, while the broader Standard & Poor’s 500 is down 5.8 per cent.

Now although there are all sorts of reasons given for this lacklustre performance – the woes in emerging markets, or the stoush between Rome and Brussels over Italy’s latest non-compliant budget – there’s little doubt that the US Federal Reserve is uppermost in investors’ minds.

That’s because anxious investors are beginning to fret that the Fed’s chairman, Jerome Powell, is of a decidedly different mettle to his immediate predecessors.

For the past three decades, investors have found huge comfort in what’s known in the markets as the “Greenspan put” – so named for the actions taken by the former Fed chairman Alan Greenspan, who obligingly slashed interest rates after the 1987 share market collapse.

He repeated this monetary nostrum so frequently – after the 1998 collapse of the Long Term Capital Management hedge fund, for example, and following the dotcom collapse in 2000 – that investors came to assume that one of the Fed’s main tasks was to clean up the mess after asset-price bubbles inevitably burst.

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Different view

Greenspan’s successors continued the pattern. After the financial crisis hit in 2008, the then Fed chairman Ben Bernanke responded with interest rate cuts and with a massive bond-buying program explicitly aimed at pushing asset prices higher.

But Powell, who took over as Fed chairman in February, subscribes to a somewhat different view. He believes the US central bank has an important role to play in curbing excessive risk-taking in financial markets, rather than simply contenting itself with cleaning up the damage.

After all, as he noted in a speech in August, “in the run-up to the past two recessions, destabilising excesses appeared mainly in financial markets rather than in inflation”.

David Rosenberg, chief economist and strategist for Gluskin Sheff, argues this is an important difference.

“It seems to me as though this prolonged cycle of Fed policy aiming to create asset cycles has come to an end with Powell,” he wrote in a client note.

“He will be every bit as transformational as [former Fed chairman] Paul Volcker was – the latter killed inflation, and the former will kill the economy’s chronic dependence on asset inflation, instead of real fundamentals like productivity.”

But investors aren’t only worried by Powell’s seeming determination to lift US interest rates in order to lean against potential asset price bubbles. They’re also worried about the timing of his rate hikes.

Since Volcker’s time as Fed chairman, from 1979 to 1987, the US central bank has used interest rates to keep inflation around the 2 per cent level.

Unpalatable combination

The problem is that although inflation is tame – the core personal consumption expenditure price index rose 2 per cent in the 12 months to August – the Fed has signalled that it plans to continue raising interest rates. That’s because the robust US economy no longer needs the heavy monetary stimulus put in place after the financial crisis.

However, this is at odds with what’s happened in previous economic cycles.

Normally, the Fed starts lifting interest rates in the middle of the economic expansion (at the beginning of 1994 for the 1992 to 1999 expansion, at the end of 2004 for the 2002 to 2007 boom). But in this cycle, the Fed started nudging interest rates higher only in 2015, even though the unemployment rate started falling in 2010.

US central bank policy makers are now signalling that they expect official US interest rates to climb to around 3.25-3.5 per cent by the end of 2019, though the US economy is almost certain to slow from the sizzling 4.2 per cent clip in the second quarter.

That leaves investors looking at a decidedly unpalatable combination – rising short-term interest rates and slowing economic activity. Little wonder the US share market is under pressure.

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