Last week the US Federal Reserve (FED) cut short term rates for the third time this year. The aim of lower interest rates is to }support the economy through more corporate and personal borrowing which eventually lead to an increase in investing and spending. A change in interest rates is one of the monetary policy tools which central bankers have in their monetary tool kit. Through a change in interest rates central banks have the ability to increase or decrease spending. When economic fundamentals and risks point to the downside, central banks usually lower rates, in order to support economic activity which in turn pushes inflation higher.
On the contrary, when an economy grows, borrowing increases, corporate investments increase, unemployment decreases and spending increases. Over the medium to long term this environment should support higher inflation rates. While a moderate, year-on-year increase in prices (inflation) is fine, central banks are mandated to keep this reading contained.
Last year the FED raised rates four times. In a span of three years, between December 2015 and October 2018, the US central bank raised interest rates a whopping nine times. Economic figures in the world’s largest economy were pointing north with unemployment levels also reaching record low levels and personal disposable income improving. Higher rates in the US were the complete opposite to what we are now accustomed to in the eurozone, where rates remain at ultra-low levels.
Back to 2019, this year we have seen the FED partially reversing the rate hikes witnessed in the previous years. For market participants and followers of business news, the shift in monetary policy came as no surprise. Towards the final weeks of 2018, the FED hinted that the economy might not withstand high interest rates. This followed as a result of a softening in economic growth figures. I can recall a number of analysts and fund managers showing their disagreement with the FED’s interest rate hikes decision of 2018. Some of whom immediately anticipated two or three rate cuts for 2019. Last week, some were proved right.
The fact that global economic growth is slowing puts more pressure on the US central bank to act. In addition, the US economy is not immune to what is happening on a global level, given its openness. In fact, geopolitical tensions, the US-China trade war, Brexit uncertainties and unrests in certain parts of the world made matters worse.
The fact that global economic growth is slowing puts more pressure on the US central bank to act
We have to keep in mind that since the last financial crisis world economic growth has recovered dramatically and remained stable. From time to time an economic slowdown is inevitable, which in the process should correct any mispricing caused by irrational exuberance.
A healthy US economy is very important for the global economy. In addition, monetary policy decisions in the US have an impact on various asset classes, both domestic and internationally. In terms of currency, as a central bank cuts rates, that nation’s currency usually declines in value.
The rationale behind the currency’s decline is as follows. When a country reduces its interest rates, the yield on interest bearing investments decline, hence making future returns less attractive. Lower demand for investments from international investors results in lower demand for the currency as investors seek yield elsewhere.
So far, in the case of the US dollar (USD) against other major currencies, this has not been as pronounced, as US interest rates are still relatively high compared to the euro and the pound. Both the eurozone and the UK have their own economic problems and hence why both currencies remained generally flat to negative against the USD, despite the rate cuts this year.
How did other assets react to this year’s change in US monetary policy? Emerging Market assets were among the beneficiaries and will most probably remain among the assets to benefit from lower US rates going forward. Since the beginning of the year, the MSCI Emerging Markets Index, which tracks large and mid-sized companies across 26 emerging market countries has gone up by 11 per cent in USD terms.
In global bond markets, the rally in bond yields intensified as demand for bonds increased. An index of liquid USD High Yield total return bonds gained nearly 16 per cent since the beginning of the year, while an index of global high yield bonds recorded a 13 per cent gain when measured in USD terms. All maturities Euro Government Bonds gained nearly 9 per cent. On the equities’ side, the EuroStoxx 50 index jumped by 20 per cent while the S&P500 gained over 24 per cent when measured in euro terms.
Investors welcomed this year’s returns with open arms, following a torrid 2018. Going into the next year, asset prices may be supported through more accommodative central banks. However, investors must keep in mind that the short term gains recorded so far this year might not repeat themselves next year.
Experienced investors know that market volatility may hit markets unannounced. For the less experienced and those who have a long-term investment horizon, make sure your portfolio’s risk matches your risk tolerance with a good enough buffer to withstand volatility. Over the long-term, riskier allocations, through managed and passive diversified investments, should do the job with limited concentration and default risks. Sitting on too much cash will most probably remain an unwise decision for some years to come.
This article was prepared by Gabriel Mansueto, head of Investment Advisors at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on 2122 4410 or e-mail email@example.com.