The Federal Reserve has a new Chairman: what does the future hold for equity markets?

A changing of the guard at the US Federal Reserve has seen Jerome Powell become Chairman. He is expected to raise interest rates two or three times this year, but will this impact equity markets?

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Federal Reserve

In many respects, the global economy either thrives or swoons on the actions of the US Federal Reserve (Fed). With a mandate to maximise employment, stabilise prices, and moderate long-term interest rates, the past eight years under Ben Bernanke and Janet Yellen have been a success when viewed under this criteria. 

The big question is whether the Fed has kept conditions too loose for too long and will now have to raise interest rates faster than the market expects, ending the bull market for equities? In our view, inflation is the key to this - a decade of subdued inflation despite the quantitative easing by major central banks across the world has surprised many. Back in 2012 Bernanke faced an onslaught of criticism when the core consumer price index (CPI) rate crept above 2%, but he stood firm and didn’t increase interest rates. Today core CPI is rising once more, but is still only around 1.5%.

Nevertheless, even with inflation staying low, Jerome Powell is expected to raise rates; probably two or three times this year, which would be a sign of continuing confidence in future economic expansion. With these rate hikes baked into the market’s expectations, it would probably require four rate rises before year end to really startle investors.

US economy appears buoyant

At present the US economy is growing at a healthy pace, with double-digit profits reported across corporates in the fourth quarter earnings season. While there is concern that President Donald Trump’s tax cuts could lead to wage growth, crimping company earnings going forward, the February US unemployment data of 4.1% was coupled with lower-than-expected wage increases of 2.6% - just 0.5% ahead of inflation.

It’s difficult to pinpoint exactly why wages are not growing that fast in a healthy economy. Some experts believe it is because the types of jobs created are of low quality (the ‘gig economy’), but the real reason may be that there is more labour market slack than commonly thought. The US labour force participation rate of 63% is still 3% lower than in 2008. Any rise in wages may be enough to tempt people back into the labour force, and an increasing supply of labour would place downwards pressure on wage growth.

Should Powell raise rates two to three times this year, the markets should be able to look through the noise; stock market volatility will pick up, but that doesn’t mean the bull market will end. Corporate bond spreads, a measure of how much businesses pay in financing costs over and above government bonds, are very low indeed, which suggests a very benign outlook. In fact, corporate America has had an extended period of time to repair their balance sheets, locking in low-cost funding for years to come. This should steady the ship for the time being.

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