The central banks of 20 nations, including the Fed, accounting for about one-third of global GDP, raised interest rates in 2015, marking a global divergence in monetary policy from that of the past few years and among central banks as we head into 2016.
Not all countries are as well–positioned as the U.S. to handle the impact of rate hikes.
Volatility may result as the widening divergence in monetary policy contributes to the challenges facing some markets.
Interest rates set by many of the world’s central banks have moved lower since the financial crisis of 2008-09, but that may be starting to change. In the past six months, more of the world’s central banks have raised interest rates than cut them.
Central banks* shift to rate hikes from cuts
*76 central banks studied
Source: Charles Schwab, Bloomberg data as of 12/21/2015.
Following the move on December 16 by the U.S. Federal Reserve to raise interest rates for the first time since before the financial crisis, the central banks of Hong Kong, Mexico, Colombia, and Chile hiked interest rates. That brought the total number of central banks hiking interest rates in 2015 to 20. The nations represented by these central banks account for about one-third of global GDP. More central banks are likely to follow in 2016; some countries will be compelled to raise rates due to a currency peg to the U.S. dollar, but others, such as the Bank of England could choose to follow in the footsteps of the Fed.
The Fed has decided that the U.S. economy is able to handle interest rates above zero. We believe the global economy can withstand the less favorable financial conditions that can come with higher interest rates. In fact, world economic growth in 2016 is widely anticipated by economists to be the strongest in five years, with a rise in GDP growth close to the long-term average pace of 3.5%. But, that doesn’t mean every country is equally well positioned to manage the widening divergence in global monetary policy.
Europe and Japan
Diverging from the path of the Fed and others, the European Central Bank and Bank of Japan remain committed to zero interest rates and QE asset purchase programs in 2016. Measured in local currency, stocks in Europe and Japan may fare better than those in other regions in 2016 as improving economic and profit growth is accompanied by favorable financial conditions contributed by central banks. In addition, the financial sector, a high weighting in these markets, should benefit from the possibility of further easing from the central banks, the relatively solid economic recovery in the Eurozone, ongoing asset quality improvement, and the fact that banks are among the cyclical sectors with the lowest valuations.
However, the combination of interest rate hikes in some countries and continued zero rates in Europe and Japan is likely to result in declines in the euro and the yen in 2016. This may act as a drag on the return of unhedged investments by U.S. investors.
The Bank of England is facing a domestic economic environment similar to the Fed since the UK and the U.S. have seen similar economic recoveries. The recoveries have been approximately of the same duration, having started at the same time, and the growth rates have been similar. Also, the unemployment rate in both countries has come down to just over 5% and inflation is expected by monetary policy makers to move back to 2%.
Despite the fact that the UK economy was one of the best performers in Europe in 2015, the UK stock market was one of the worst performers due to a high concentration in the energy sector and very low weighting in technology, the worst and best performing global sectors, respectively. While the UK economy seems well prepared for the rate hikes the Bank of England may undertake in 2016, the UK stock market may continue to lag reflecting our outlook for lingering weakness in energy and continued strength in technology.
Australia and Canada
Both of these resource-driven economies ended interest rate cuts in mid-2015 and their central banks are likely to be on hold in 2016. On the day the Fed hiked rates in the U.S., global oil prices tumbled another 5%. While these countries may not directly experience the headwind of rising rates on their domestic economies, a rising dollar driven by Fed rate hikes may continue to push down on commodity prices in 2016 and weigh on the economies and stock markets of these commodity exporting countries.
China has tried to insulate itself from Fed interest rate hikes by shifting their currency from a peg to the U.S. dollar to a basket of currencies that includes the euro and yen, where no rate hikes are anticipated in 2016. This may help to stabilize the value of the renminbi versus China’s trading partners after years of steady appreciation, as you can see in the chart below.
China’s currency has tracked the value of the dollar higher versus major trade currencies
Source: Charles Schwab, Bloomberg data as of 12/18/2015.
In response to Fed rate hikes prompting capital outflows from China, we expect China to continue to lower interest rates and the reserve requirement ratio in 2016 to help boost liquidity. China’s economy is likely to continue to slow in 2016, but the shift in currency away from the rising dollar along with rate cuts from the central bank may lend some support to the economy and stocks next year.
Some emerging market economies are not as well positioned as the U.S. to handle higher rates. For example, Brazil has had to raise interest rates in 2015, despite a recession, to lend support to a weak currency. Even when an economy is faring reasonably well, the impact of a sharply falling currency can cause stock market returns to suffer. Mexico is an economy that has been faring well and its stock market has posted a positive total return in 2015, when measured in local currency. However, 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.
There may be some winners in emerging markets in next year thanks to faster global economic growth, a big improvement in current account balances, and attractive valuations. But the various impacts of rate hikes by some countries in 2016 may mean that, as an asset class, emerging market stocks may lag those of developed markets in 2016.
This divergence in monetary policy is a risk for stock markets in 2016 and is likely to contribute significant volatility. Global central banks helped to lower stock market volatility and support valuations on the downside in recent years by cutting rates or adding to QE programs if growth disappointed. The opposite may be starting to happen now as global monetary policy begins to shift. If growth were to surprise to the upside, the perception that central banks may withdrawal stimulus more quickly may limit the stock market’s upside, capping valuations and driving volatility.
The validation of the improvement and sustainability of global economic growth represented by the start of rate hikes by some central banks is encouraging. But while economic growth is likely to accelerate in 2016, so is the volatility in global stock markets as a widening divergence in monetary policy contributes to the challenges facing some markets.