Will interest rates derail markets?

What happens to interest rates locally and globally is always important for investors, but particularly so at turning points in the economy.

And notwithstanding the recent Omicron outbreak, the world’s most influential central bank, the US Federal Reserve, looks likely to lift interest rates as early as March. It would be the first increase in more than three years and marks a significant turning point in the global economic cycle. Higher rates in the United States will impact equity, bond and currency markets around the world.

Prices in the United States are still rising well above comfortable levels.

Last month, core inflation in the world’s largest economy rose 5.5 per cent, year on year. That was the highest annual rate in 30 years. Headline inflation was at 7 per cent, a 40 year high. Some of the biggest jumps were in energy, transport and rents.

The data shows that Omicron is set to further disrupt supply chains and continue to show up in inflation this year. Goods prices remain under pressure as quarantine rules and sick leave result in lower staff levels and inventory levels. And services prices are likely to rise in 2022 as demand increases back to pre-COVID levels.

Federal Reserve chair Jerome Powell isn’t shying away from higher interest rates, recently saying the Fed was prepared to do what was necessary to contain the current inflation surge. “We will use our tools to prevent higher inflation from becoming entrenched,” he said.

Notably Chair Powell said many inflationary issues stemmed from pandemic related supply chain and labour force shortages and the risks are lingering, potentially for longer. He said: “It’s a long road to normal from where we are now.”

The Fed is likely to lift interest rates as early as its March meeting, from the current interest rate target of 0-0.25 per cent, to 0.25-0.50 per cent. It’s likely to lift interest rates three or four times this year.

So, will the rest of the world follow the lead of the Fed?

Rate rises in the world’s largest economy will contribute to a more volatile ride for Wall Street and global shares. But it’s unlikely to be enough to end the economic recovery and cyclical bull market as monetary policy will still be relatively easy.

Other major central banks, including the Reserve Bank of Australia (RBA) will lag the US, with China’s central bank actually easing monetary policy this year.

In Australia, the breadth of inflation pressures is far narrower than in the US with 75 per cent of US CPI components rising more than 3 per cent during December, compared to only 35 per cent in Australia.

Nevertheless, the recent December quarter inflation data was much stronger than the RBA expected.

Australian core inflation was running at 2.6 per cent over the year to December, which is the strongest pace of growth since 2014 and firmly within the RBA’s 2-3 per cent target range for inflation. The quick acceleration in domestic inflation and the strong conditions in the employment market that should see a lift in wages growth mean a quicker start to RBA interest rate hikes. We expect the first rate hike in August, taking the cash rate to 0.25 per cent (from 0.1 per cent currently).

For global equity markets, inflation will continue to be a dominating force in 2022.

Global shares are expected to return around 8 per cent this year but expect to see the long-awaited rotation away from growth and tech heavy US shares to more cyclical markets in Europe, Japan and emerging countries.

Inflation, the start of Fed rate hikes, the US mid-term elections and China/Russia/Iran tensions are likely to result in a more volatile ride than 2021. Mid-term election years normally see below average returns in US shares and since 1950, have seen an average top-to-bottom drawdown of 17 per cent, usually followed by a stronger rebound.

Australian shares are likely to outperform, helped by stronger economic growth than in other developed countries, leverage to the global cyclical recovery, and as investors continue to search for yield in the face of near zero deposit rates but a grossed-up dividend yield of around 5 per cent. Expect the S&P/ASX 200 to finish 2022 around 7,800.

Although the Australian dollar could fall further in response to coronavirus and Fed tightening, a rising trend is likely over the next 12 months helped by still strong commodity prices and a decline in the $US, probably taking it to around $US0.80.

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Reproduced with the permission of the AMP Capital. This article was originally published at https://www.ampcapital.com/au/en/insights-hub/articles/2022/january/will-interest-rates-derail-markets
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