Impact of US rate rise on SMSFs
Markets are divided as to whether the US Federal Reserve will lift official interest rates in the US this year. Any future rate rise, this year or next, will have a significant impact on global financial markets.
It’s important SMSF investors are aware of this and understand any potential consequences for their portfolio.
AMP Capital’s house view is that US interest rates will increase by 0.25% by the end of the year. The question, says AMP Capital economist Diana Mousina, is whether this will be in September or December.
“Investors should still consider there is the potential for a rate rise in September. But the Fed's still uncomfortable with recent data. So any rate rise in September is probably too soon. But we think the US economy will be stronger in the second half of the year, which will give the Fed more reason to lift rates,” she explains.
Mousina says US economic growth was below expectations for the first half of 2016. Forecasters have also downgraded the outlook for US economic growth. For instance, the non-partisan Congressional Budget Office (CBO) says “the growth in GDP that CBO now projects is slower throughout the 2016–2026 period than the agency projected in January.”
“We think US growth will be about 2% over 2016, with the stronger part of that growth in the second half of the year. The labour market is one area where we've seen positive data. The US unemployment rate is about 4.9%, below the 5% rate we equate with full employment,” she says.
However, inflation has been below market expectations, reaching 1.6% according to the July PCE Index, below the US Federal Reserve’s target of 2%.
“We expect labour market pressures will flow through to inflation. But that will take time, and interest rate changes also take a while to work through the economy. So even if the Federal Reserve raises rates in December, the impact on inflation might not be felt for another year to 18 months,” says Mousina.
Impact on equities and fixed income
Any rate rise in the US is likely to affect equity and fixed interest markets. But it is difficult to predict what this impact will be.
“You might expect interest rate hikes to be negative for the equity market, but it really depends on forward projections for the US economy. Even though the Federal Reserve raised interest rates in December last year, the equity market in the US recently reached a record high,” says Mousina.
“So it is not always the case that just because there is a rate hike, there will be a downturn in equity markets. What is more important is market expectations about future interest rate movements. If the Federal Reserve’s commentary indicates rate hikes will be gradual, that will probably be taken as positive by the equity market, because monetary policy in the US won't be tightened too quickly,” she explains.
Mousina says global share markets are undervalued compared to fixed interest markets, although they are more volatile. Nevertheless, because US share markets are at a record high, a retraction is a distinct possibility.
“In terms of fixed interest, it's still an important diversifier in a portfolio. But the bond market rally is likely to be dampened as inflationary pressures increase and the US starts to raise interest rates.
As to what SMSF investors should be doing to prepare for any potential US rate rise, Mousina says the key is to ensure the portfolio includes a wide spread of different assets.
“When the largest market in the world raises interest rates, it tends to prompt bouts of market volatility. With a huge event risk like interest rate hikes, diversification is key,” she says.
However, what’s key is the pace of US rate rises. Says Mousina: “Any interest rate rise indicates the largest economy in the world is back on track and growth is sustainable. One or two interest rate hikes over the next 12 months should be expected by markets because it’s important for the US to return to more normal monetary policy settings after a long period of easy monetary conditions.”