The US share market has staged a remarkable rally since it hit lows in 2009, but with the American economy now adding jobs at a stunning pace a normalisation of interest rates has become inevitable.
But will the US Federal Reserve move ahead or be caught behind this cycle?
We believe that normalisation of cash rates in the US will trigger the end of that great post-GFC rally over the next two years as bond yields and PE ratios also normalise.
Figure 1. S&P 500
Source: Yahoo!7 finance
The good news is that there will still be opportunities for investors in stocks exposed directly to the US economy as employment and consumption rebound, such as McDonalds and Walmart.
The US economy added 329,000 jobs last December; then another 257,000 in January despite the impact of terrible snow storms. America is now creating one million new jobs every three months.
Indeed, it’s likely the US will create somewhere between 3.5 to 4 million jobs this calendar year.
American employment growth is back above historical trends, and the numbers confirm America is increasing economic growth up a notch.
That jobs creation means more people consuming and paying tax which is good news for the US budget. (However, a balanced budget is still not being forecast given rising spending on healthcare and low corporate tax payments.)
The Fed’s dilemma
The problem is that employment growth is now translating into wages growth: wages grew 0.5 per cent in January, the fastest since the GFC.
We expect American growth to continue and create ongoing upward pressure on wages, which will be more apparent in the June quarter.
The US Fed now faces a difficult dilemma (largely due to Europe’s belated move to implement quantitative easing).
Employment and wages growth obviously increases pressure on the Fed to raise rates to avoid a ‘cost-push’ (inflation caused by higher production costs) inflation cycle.
If they don’t raise rates, the US is going to have potential issues with asset speculation and further wage pressure growth as unemployment edges towards 5%.
But if the Fed increase rates, that puts upward pressure on the $US, which will hurt US corporate growth. The Fed clearly doesn’t want the $US spiralling up and damaging its competitiveness.
How will this play out?
We believe that in the short term the threat of a higher $US means the Fed’s hands are tied; we will see more of the same and rates won’t rise quickly.
But the pressure is building. We are nearing an inflection point. So over the next two years market interest rates will normalise due to higher costs coming through in wages – indeed the Federal Reserve may be belated in their response.
That obviously has implications for investors.
Since 2009, we have witnessed a great post-GFC rally in US equities, with low yields driving an expansion of price-to-earnings ratios (PEs) as required rates of return fell.
The rally ends
A normalisation of US interest rates will lead to a normalisation of bond rates. That, in turn, will see a normalisation of PEs.
The loss of PE expansion as a driver will see the US stock market go sideways and tread water over a couple of years.
Basically, we will see an end of that great broad based US equity market rally.
This scenario bodes well for being short the $A, as we have recommended for some time. There are also opportunities for investors in inward-looking US companies leveraged to employment and consumption growth.
That includes retailers, fast-food stores, and property funds. The likes of Walmart, McDonalds, Yum Brands and General Motors should be on the watch list for investment.