Reflecting on February: Markets at record highs

Stock market highs and the probability of interest rate hikes

We reflect on February’s stock markets reaching record highs and the probability of policy change by the US Federal Reserve, considering what these could mean for investors.

Stock markets break records

What has happened?

Equity markets continued to rally in February, with a number of indices reaching new record highs. The MSCI World Index – which represents large and mid-cap equity performance across 23 developed market countries – rose a relatively modest 0.8% during the month but the gain was sufficient for it to post its highest level on record. In developed markets, it was once again US equity indices that were amongst the strongest performers, in particular the Dow Jones Industrial Average which posted a new closing high on 12 consecutive days between the 9th and 27th February.

Why?

The broad rally in global equity markets since June has coincided with a period of improving prospects for economic growth and expectations of rising inflation. Ongoing monetary and fiscal stimulus in China have allayed fears over slowing growth in the world’s second largest economy, while Donald Trump’s pledge of a $1tn infrastructure spend and lower corporate and personal tax rates are considered to be supportive of both growth and inflation. Elsewhere, the UK economy has held up well in the aftermath of the country’s vote to leave the European Union, potentially assisted by the stimulatory impact of a decline in sterling. In the Eurozone, economic data has been strong in spite of heightened political uncertainty. February saw generally improving prospects for both growth and inflation, with the Citigroup Global Economic Surprise Index – a measure of aggregate economic data surprises – rising to its highest level since 2010, helping to sustain the equity market rally.

What should you take away from it?

If we consider improving global growth prospects to have been an important factor in the equity market rally over the last nine months, then it would seem reasonable to see expectations of global economic performance as influencing the direction of equity markets going forward. Therefore, economic data and, perhaps more importantly, factors that could drive changes in economic data – such as fiscal stimulus and political events – are likely to be closely followed by financial markets over the coming months.

Are we set for a US rate hike in March?

What has happened?

With accommodative monetary policy having played such a key role in financial markets since the financial crisis, one could argue that more attention than ever is paid to central bank meetings. In the US, Fed fund futures are used to calculate a market implied probability of policy change by the US Federal Reserve at each of its meetings. Having raised rates in December 2016, and with improving growth prospects as referenced above, expectations, as measured by the futures market, are for the Fed to raise interest rates at least two more times this year. At the start of February, however, the chances of the first hike coming at the Fed’s Federal Open Market Committee meeting on the 15th March were reasonably low at 31%. On the 1st March, however, the implied probability of a rate rise had risen to 82%.

Why?

Macro data released in February has generally painted a picture of a US economy close to fulfilling the Fed’s objectives of maximum employment and stable prices. While the Fed does not have an explicit unemployment rate target, the current jobless rate of 4.8% is below the long-term average and is likely close to ticking the maximum employment box. With regards to stable prices, the FOMC targets an inflation rate of 2%; the core PCE deflator – the Fed’s favoured measure of inflation – currently stands at 1.9%. Of course it is not just these two numbers that dictate Federal Reserve policy decisions, but FOMC members themselves have remarked that they are close to reaching their goals and that it may be appropriate to tighten policy soon. Chair Janet Yellen told Congress in February of the “considerable progress the economy has made toward the FOMC’s dual objectives”, while William Dudley, head of the New York Fed said that the arguments for raising rates has become “a lot more compelling in recent months”.

What should you take away from it?

There can be the perception that higher interest rates are something to be concerned about. While higher rates can lead to an increase in borrowing costs and can impact the valuations of certain asset classes, tightening monetary policy is often a response to improving economic prospects, as is the case here. Central banks need to be confident not just that the economy is improving, but that it will continue to do so, even with higher interest rates, and William Dudley stated in February that there has been evidence that makes the Fed “even more confident” that the US economy is set to continue on its current trajectory. Furthermore, it is worth bearing in mind that interest rates remain extremely low by historical standards, with little scope to be lowered should it become appropriate. Raising interest rates, therefore, does return to the Fed’s ‘toolkit’; an instrument (lowering interest rates) to support the US economy should it be required in the future.