Reflection by the stock markets before the interest rate hikes

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December 8th, 2015

Constructive tone in the markets while they prepare themselves for the decoupling between the Fed and ECB. The risk aversion of the last few months has diminished thanks to less uncertainty concerning growth in the emerging economies and the Fed's more specific message regarding its monetary normalisation strategy. The latest macroeconomic figures in the US have notably boosted expectations that the US central bank will finally decide to raise the federal funds rate at its December meeting. In turn, the ECB has repeated its willingness to approve more monetary stimuli at the start of December, consolidating the strength of the dollar. This apparent divergence in monetary policy on both sides of the Atlantic is likely to materialise in the ECB and Fed meetings in December (on the 3rd and 16th, respectively), resulting in further decreases in the dollar/euro exchange rate and widening the gap between yields on 10-year US and German bonds. We expect monetary normalisation to be very gradual with a limited impact on share prices, which are high at present but not necessarily overvalued. Although the environment for US stocks still has some room for gains, more moderate yields are expected than in previous cycles, with some acceleration in Europe (see the Dossier article «2016: challenges and opportunities in a demanding global financial environment»). For the emerging countries, attention remains on China where there are still downside risks in the economic scenario. Nonetheless, we believe that the active role played by local authorities in economic policy throughout 2016 will continue to effectively limit the sources of risk threatening the Chinese economy.

The dominant factor in the US will be the pace of interest rate hikes as the actual date of the start of normalisation becomes relatively less important. In addition to the healthy macroeconomic figures announced recently is the publication of the minutes from the Fed's October meeting revealing that the majority of members are in favour of beginning monetary normalisation. Given this situation, the markets have significantly increased the probability assigned to this event, going from 35% in October to 76% by the end of November. Investors are now focusing on the speed at which the rest of the increases will take place until the equilibrium interest rate is reached, which the Fed places at 3.5%. The consensus of analysts expects a markedly more gradual path than in previous cycles when monetary conditions have been tightened. Specifically, the Fed's projections show an annual increase in the federal funds rate of 0.9 pps compared with an annual average increase of 1.7 pps (on this issue, see the Focus «A federal funds rate hike: this time is different»).

Investors are keeping an eye on inflation in the euro area while waiting for the ECB to act. Although underlying fundamentals continue to point to a gradual economic recovery in the euro area, inflation expectations are still below the ECB's target. For this reason, and although the institution might refuse to act before 2016, investors increasingly expect an announcement of greater stimuli at the next meeting on 3 December and the derivatives market is discounting a cut of 10 bps in the deposit interest rate. It should be noted that, although any substantial changes in the quantitative easing programme are very unlikely, the ECB might extend the scope of QE by including regional and local debt securities.

The ECB effect can be seen in Europe's sovereign debt market after the upswing in yields caused by the Fed's plans. Concern for the response by the long part of the US interest rate curve has eased to some extent. The yield on 10-year US bonds seems to be reacting flexibly to the different events that tend to affect its performance, rising in November by 6 bps up to 2.23%. This upswing in US bond yields also pushed up yields on European sovereign bonds. However, the effect of Mario Draghi's announcement, and subsequent messages from various ECB members regarding possible additional stimuli, ended up widening the spread between the German bund and its US peer to 1.8 pps, one of the largest since the crisis. In turn, peripheral risk premia have relaxed slightly, as well as the spread between Spanish and Italian 10-year bonds which has shrunk from the 25 bps observed mid-November to 10 bps. Nevertheless the relative trend in Spanish debt is likely to be less favourable in the days prior to the country's general elections although we do not expect any great tensions to appear once the results have been announced.

Volatility has eased in emerging markets but they are still being closely watched by investors. Although China's transition towards an economic model that is based more on consumption and services has provided mixed activity data, most indicators have stabilised considerably. Given this situation of an orderly slowdown, the Chinese central bank is very likely to opt for more accommodation with additional cuts in official interest rates, especially if inflation remains at a low level, which seems probable. On the other hand the IMF has approved the inclusion of the yuan in its basket of benchmark currencies. This decision by the institution represents, on the one hand, recognition of the measures taken by the Chinese government to promote market forces and, on the other hand, it provides a clear incentive for the Chinese authorities to continue moving along these lines.

International stock markets slow up their gains in October, raising doubts as to the acheivement of their annual maximums. The stock markets sailed through November with slight advances and some volatile episodes. October's rally was followed by doubts regarding the mixed data from China and uncertainty caused by the Paris attacks and, as of today, the annual peaks reached by the developed stock markets in spring have yet to be regained. Shares are still suffering from considerably larger corrections in the emerging bloc than in developed stock markets. The end of the earnings season confirmed that the commodities crisis has affected profits significantly, both in Europe and especially in the US. Here the earnings per share (EPS) fell by 5% year-on-year but, without the energy sector, they rose by 2%. Euro area companies recorded the strongest growth in EPS of all advanced economies (2% or 6% without the energy sector) and continue to auger a solid cycle of stock market gains in the future. For the rest of the year some positive impact is expected from the announcements of important dividend payments. The high share prices for US assets compared with European stock continue to make European markets more attractive than the US.

The strength of the dollar and distress of commodities are affecting the trend in emerging currencies. In November the euro reached its lowest level against the dollar since the summer and came close to its lowest value in 10 years, reaching 1.06 dollars. Short positions on the euro in the futures and options market increased considerably in October and November, in line with expectations of divergent strategies by the Fed and ECB. Emerging currencies are still keeping an eye on the evolution of commodities and on US interest rate hikes. In the commodities market, the rally by the main commodities (oil, copper and zinc) in October was brief and these have now returned to their particular downward cycle.