Investors though should not only focus on larger companies, according to Viktor Nossek, director of research at WisdomTree in Europe. He believes that smaller cap stocks which have a home bias will fare better because they will not be as impacted by any currency appreciation triggered by a rising rate environment.
“Also, small companies are well positioned because they tend to have less leverage on their balance sheets than their larger counterparts,” he says. “The investment case is also strong because the economic and political uncertainties have diminished. If you compare the performance year-to-date, MSCI’s small cap index is up almost 18% versus the 11.6% of the MSCI Europe Net Total return Index.”
This is in sharp contrast to the start of the year when markets were jittery ahead of a full calendar of elections, most notably in the Netherlands, France and Germany.
Although populist parties did make headway – the right wing AfD won seats in the German parliament for the first time in half a century – there was a sigh of relief that the Angela Merkel-led CDU/CSU was the country’s largest party while equities rallied on Emmanuel Macron’s victory in France.Equally as important, growth in the eurozone is motoring along at a healthy clip with the region expected to produce its best set of results this year in a decade.
Estimates from the European Commission show GDP rising to 2.2% this year from a 1.7% estimate in May, while in 2018 the rate will only moderate slightly to 2.1% against a previous estimate of 1.8%.
There will also be plenty of liquidity sloshing around the system to act as a cushion. Starting from next year, the European Central Bank (ECB) is halving its monthly bond buying purchases, but they will still be plentiful at €30bn. The ECB has also not signalled an end date to its quantitative easing programme and interest rates, unlike in the US and UK, are not expected to rise until mid-2019 at the earliest.
By contrast, the US Federal Reserve has raised interest rates on four separate occasions since the end of 2015 and has started to pare back its $4.5trn balance sheet to a target of $3trn by 2021. While the market expects another 25 basis point hike in December, some participants believe that future rises may be sharper. “A major risk – currently underestimated by analysts and not visible in market pricing – is the potential for US policy rates to increase much more rapidly than anticipated right now,” says Gero Jung, Mirabaud Asset Management’s chief economist.
“In our view, market forecasts of only one policy hike next year are too low,” he adds. “We side more with the Fed’s median projection of three hikes next year. Indeed, if the labour market tightens further and wage pressures begin to slow more substantially, US policy rates might increase much more steeply, with negative repercussions, for instance, for vulnerable, high current account deficit, emerging markets.”
Although some fund managers are keeping their distance, Shoqat Bunglawala, head of global portfolio solutions for EMEA and Asia Pacific strategies at Goldman Sachs Asset Management, believes US equities can absorb a rise in 10-year bond yields to around 3% without a sustained sell-off. “We would expect markets to become more volatile from here, but not dramatically so, and recommend a dynamic approach to the asset class.”
Bunglawala also thinks that emerging markets offer better prospects than their overvalued developed market counterparts over the medium term. Not only are growth rates strong, and valuations more attractive, but given the progress made on resolving macro imbalances they are somewhat less susceptible to rising rates and some countries are benefiting from stable commodity prices.
WINNERS AND LOSERS
The International Monetary Fund (IMF) strikes a more bearish note on the UK, singling it out as a “notable exception” to an improving global economic outlook. In its twice-yearly World Economic Outlook, the IMF sharply reduced its UK long-term view, from an estimated annual growth rate of 1.9% to 1.7% due to concerns over Brexit.
There are though some bright spots in the UK equity market, according to Laith Khalaf, senior analyst at Hargreaves Lansdown. He points to financials as a beneficiary of rising interest rates because it allows them to make a bigger margin between the money they take on deposit and the money they loan out to individuals and businesses. “Lloyds and RBS are the two FTSE 100 banks who stand to benefit most from UK interest rate rises, but current expectations of rate rises will be partly factored into share prices,” he adds.
