On Friday night, US investors were left in little doubt that interest rates will rise at the December meeting of the US Federal Reserve Open Market Committee, after much stronger than anticipated growth in jobs in October. This certainty stood in contrast to the response in the Asia Pacific region on Monday – share markets were all over the place. In reaction European and US share markets are under pressure. What do rising US interest rates mean for your investments?
Rising interest rates are generally bad news for companies. Most businesses are leveraged in some ways, and higher interest rates means higher debt servicing costs. Additionally, interest rates are a key input to the valuation models analysts and investors use to estimate “fair” share prices. Higher rates also mean lower share valuations.
Theoretically then, higher interest rates should mean lower share prices. Yet studies show that share markets generally rise during the first two years of a tightening cycle. This is often attributed to the broader economic conditions. Although an improving economy implies rising costs, activity and prices also get a boost, and the net effect on company profits is a positive. In other words, share markets appear to respond the improving economy that is driving rates higher, rather than the additional costs associated with rate hikes.
So your portfolio of Australian shares is looking good? Maybe. There are other effects for investors to consider.
An important factor for the ASX is the impact on commodity prices. When all else is equal, a rising USD pushes commodity prices lower. (Of course, things are never equal). This fall in commodity prices is offset by the fact that producers are now earning more valuable USD when converted to AUD. However, this offsetting currency impact is not immediately visible to investors, and the first blush reaction is likely to see further resource share price pressure.
Eventually, the higher AUD revenues “come out in the wash”, usually at the resource company’s next results announcement. This is why some investors will treat any further share price falls in materials and energy stocks as an opportunity to re-balance portfolios for the long -term, adding to metals and gas exposures at current lower share prices.
Another effect to consider is the potential for investment flows to shift. Higher returns in the US are expected to attract investors, usually at the expense of emerging markets.
As global investors move away from the Asia Pacific region, there may be share price pressures reflecting these investment flows. While this is an investment effect, rather than an economic hit, the impact of falling asset prices varies from mild caution to outright panic, with little predictability. From an investment point of view, Australia has characteristics of both a developed and emerging economy, and whether or not it will suffer from investment outflows is not clear. However, the potential for short sharp sell offs in the region is increased, with the consequent knock on effect to local shares.
A lift in US rates leading to a stronger USD is not entirely negative for investors, and not just because the world’s largest economy continues to improve. First reactions in Japan saw share prices jump by 2%. The thinking is that a weaker JPY (stronger USD/JPY) will see Japanese investors taking advantage of the currency move and bringing investments home, presumably to invest in local shares. Positive performances in the region will likely aid sentiment.
The overall impacts of higher US rates are somewhat two sided. Markets are buoyed by the better economic conditions, but hamstrung by higher rates and changed investment flows. This is likely to see a further increase in volatility as markets adjust to the new environment.
The investment rewards this year are flowing to active investors – those who are willing to sell when prices are higher and buy when they’re lower. While rising rates introduce another factor to the investment environment, this dynamic will likely remain the main driver that determines investment success.