Investors turn to risky assets as central banks push the limits of monetary policy

3rd November 2015


BlackRock’s Russ Koesterich looks at how global markets are responding to central bank tactics…

With the possibility of a December hike in US interest rates back on the table, bond yields rose last week (as prices fell), and investors continued to favor stocks, despite already high valuations. The yield on the 10-year Treasury rose from 2.09% to 2.15%, and two-year yields advanced as well. Meanwhile, stocks posted modest gains. The Dow Jones Industrial Average inched up 0.09% to close the week at 17,663, the S&P 500 Index was up 0.19% to 2,079 and the tech-heavy Nasdaq Composite Index advanced 0.44% to 5,053.

Although interest rates are little changed year-to-date and likely to remain range bound, the renewed prospect for higher rates in the US and the opposite trend elsewhere in the world is once again pushing the dollar higher. However, a continued strong dollar would represent a headwind for US inflation, precious metals and US company earnings.

Reacting to the Fed

The Federal Reserve (Fed) issued a statement last week that acknowledged continuing concerns around international developments, but also left the door open to a December rate hike. The US central bank’s decision to pursue that path will hinge on the next several weeks of data. Still, investors were somewhat surprised by the Fed’s tone. The odds of a December hike increased from 35% to 50%, two-year yields rose and the dollar advanced.

To be clear, the recent rebound in the dollar is being driven as much by events in Frankfurt and Stockholm as by the Fed. Most other central banks are racing in the opposite direction of the Fed. The latest example was the Swedish Riksbank, which expanded its bond-purchase program for the fourth time since February. While US two-year yields are paltry at less than 1%, they look tantalizing relative to Europe; two-year yields are negative in France, Germany, the Netherlands and Switzerland.

Given the renewed divergence in global interest rates, it should come as no surprise that the dollar is once again rallying, hitting a two-month high last week before surrendering some of its gains on Friday. With the dollar appreciating and inflation expectations remaining moribund, there is considerably less demand for inflation hedges such as gold and silver, with both declining last week.

Driving stocks higher

Instead, investors are going back to stocks and, for now, overlooking the fact that a stronger dollar would put further downward pressure on US earnings. Last week, US equities advanced with investors encouraged by solid numbers from Apple as well as generally better-than-expected earnings from several pharmaceutical companies. Stocks also benefited from the removal of tail risk as Congress voted to extend the US’s borrowing authority through March of 2017 and passed a two-year spending deal, in the process averting both a technical default and government shutdown.

But by far the biggest driver of markets has been multiple expansion. With central banks further testing the limits of monetary policy, investors are once again reacting, as if on cue, by buying risky assets. This process is furthest along in the United States. The trailing price-to-earnings ratio (P/E) on the S&P 500 has risen to 18.5, slightly below the summer peak. Valuations are now up roughly 12% from the August lows, accounting for all of the market’s rebound.

Going into 2016, a stronger dollar and the advent of a tightening cycle, even a gentle one, will impede both earnings growth and further multiple expansion. In contrast, the actions of other central banks are likely to continue to bolster market valuations.

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