Advisors and the markets understandably have been focused on the Federal Reserve’s path to raising interest rates, with the first iteration occurring Dec. 16 and a consensus that several more hikes are likely in 2016. Such a focus may be understandable but overlooks how the world’s other central banks are dealing with monetary policy. As Jeffrey Kleintop warns, this myopia ignores the volatility “that may result as the widening divergence in monetary policy contributes to the challenges facing some markets.”
Kleintop, chief global investment strategist for Charles Schwab, points out in a Dec. 21 note that 20 central banks around the globe raised interest rates in 2015; those countries account for a third of global GDP. More central banks are expected to raise rates in 2016, he says — some compelled to do so since they peg their currency to the dollar. Others, like the Bank of England, will follow the Fed because they think, like the Fed, that their economies can handle “the less favorable financial conditions that come with higher interest rates,” and since their GDP growth rate is similar, unemployment has fallen to around 5% in both the U.S. and the U.K. and inflation remains tamed.
But while the global economy can handle higher rates — and will contribute to global GDP growth of close to 3.5%, Kleintop predicts — many individual countries will struggle with higher rates, and many central banks are still engaged in quantitative easing, such as the European Central Bank (ECB), the Bank of Japan and China.
As measured in their local currencies, European and Japanese stocks may perform relatively better next year, particularly since the financial sectors in Europe and Japan will be helped by further easing. However, Kleintop thinks that when combined with rate hikes in other countries, both the euro and the yen may well decline next year, which “may act as a drag on the return of unhedged investments by U.S. investors.”
By contrast, China’s currency, the renminbi, may stabilize as a result of the government’s decision to shift their currency from a dollar peg to the International Monetary Fund’s SDR, a basket of currencies that includes the euro and the yen, “where no rate hikes are anticipated in 2016.”
Kleintop says Schwab’s analysts expect China “to continue to lower interest rates and the reserve requirement ratio in 2016 to help boost liquidity.” So while China’s economy “is likely to continue to slow in 2016,” the shift to the SDR combined with rate cuts from China’s central bank “may lend some support to the economy and stocks next year.” Among the countries that are likely not to handle higher rates well are some emerging markets, notably Brazil, which was forced to raise rates in 2015 despite being in recession in order to bolster a weak real. Currency issues are affecting Mexico as well. While its economy has been “faring well” and its stock market “posted a positive total return in 2015, when measured in local currency,” in U.S. dollars, the Mexican Stock Exchange Bolsa IPC Index has suffered a double-digit loss this year thanks to the decline in the value of the peso versus the dollar.”
Monetary policy divergence among the central banks may also spur more stock market volatility, Kleintop argues. Why? For the past several years, central banks tamped down volatility and offset slow growth by cutting rates and instituting or adding to quantitative easing programs. But if economic growth were to “surprise to the upside,” central banks’ tendency to withdraw stimulus programs more quickly could “limit the stock market’s upside, capping valuations and driving volatility.”
— Check out Seeking Income When a Fed-Induced ‘Winter Is Here’ on ThinkAdvisor.