How will volatile markets react to US rate hike?

Market ructions are set to continue this year as the monetary policies of major central banks begin to diverge, experts say.

The Federal Reserve has finally raised interest rates by 25 basis points in response to improving  economic data.

But Pictet Wealth Management head of asset allocation and macro research Christophe Donay says uncertainty over the timing and magnitude of any future rises, coupled with the “imbalances created by the desynchronisation of central bank policies”, means market volatility will increase this year.

Donay says: “We expect a gradual rise in rates on 10-year US treasuries to 2.7 per cent by the end of 2016 as monetary policy tightens.

“However, US treasuries will likely remain attractive to protect portfolios against shocks to equity markets. Although the Fed’s historic rate rise looks to have passed off smoothly, the calm in markets is unlikely to last long.”

During 2015, commentators argued the trajectory and end-point of rate hikes were the key concerns for investors.

Aviva Investors head of multi-asset Peter Fitzgerald says there is a “reasonable possibility” the Fed will raise rates faster than 25 basis points per quarter, arguing the US economic outlook will improve further.

However, he adds: “The first rate rise is not going to have a negative impact on markets. It is only when you get further down the road on the other hikes that you’ll see impacts on bonds and equities.”

Research suggests ahead of the rate rise investors shifted into safer asset classes.

For example, average cash holdings jumped from 4.9 per cent to 5.2 per cent in November as investors aimed to protect their assets from volatility, according to a fund manager survey from Bank of America Merril Lynch.

Lombard Odier Investment Managers head of systematic equities and alternatives Alexandre Deruaz says this year investors should focus on companies with larger dividends as they offer better protection against any further rates hikes. He says: “Companies with smaller dividends and larger growth tend to suffer more than typical value stocks. In short, ‘cheap’ stocks that offer good value given their assets and earning potential fare better than expensive growth stocks when rates increase.”

Other experts, however, argue the US Federal Reserve has moved too late, creating excess liquidity in the market and, consequently, valuation distortions.

Tilney Bestinvest managing director Jason Hollands says: “Bond yields had already nudged higher in expectations of rate rises, so with the costs of borrowing already increasing, there will be less incentive for US companies to pursue debt-financed share buybacks. These have been the key driver that has turbo-charged the US equity bull market of recent years.

“We remain cautious towards US equities and to relatively favour those regions where rates  remain low and money-printing programmes are in full-steam, notably Europe.”

Hollands is cautious on both equities and bonds for 2016 amid fears of a potential dislocation that could occur as monetary policies diverge between regions and “the continued spectre” of the slowdown in China.

He also says in the medium term investors should reconsider absolute return funds that pursue low volatility strategies as they are not reliant on directional movements in markets.

Royal London Asset Management economist Ian Kernohan says the market may have to revisit its “benign” view of the likely path of US rate rises if labour market data remains robust and  inflation rises.

He says: “Bond markets would be most vulnerable to such a reappraisal, in particular government bonds, which have enjoyed a multi-decade bull run of falling yields.”

Investors remain cautious of the implications of the Fed moves for emerging markets, especially for those burdened with dollar-denominated debt.

Schroders co-head of emerging markets debt relative James Barrineau says while all asset classes had waited for the Fed to move, emerging markets were arguably one of the most affected as the average currency in the asset class has fallen roughly 40 per cent since May 2013, when the US began its taper tantrum programme.

He adds: “A more predictable and less fraught path going forward for the Fed should help steady investor nerves and risk appetite.

“If developed market bond yields remain very low emerging market dollar yields may remain one of the few places to look for meaningful income generation for years to come.”