The big question mark hanging over the global economy is when the US Federal Reserve will finally start hiking interest rates.
And the question facing UK investors is what impact that will have on the FTSE 100Â and other indices.
Fed chair Janet Yellen has already warned that stock markets valuations look âquite highâ and potentially dangerous.
Some argue the first rate hike could mark the end of a global asset bubble fuelled by cheap money, and forcing highly indebted countries into meltdown.
How nasty could it get?
Getting Closer
The first momentous rate hike has edged a little closer after last week’s figures showing US employers created 223,000 jobs in April, well up on 126,000 in March, taking unemployment to seven-year low.
The numbers were good, although they weren’t that good.
Nobody is seriously forecasting a rate hike in June. September looks iffy. Citigroup is eyeing December.
There is always a chance that the US recovery will stall, and push that first rate hike into 2016.
The feeble first-quarter GDP growth figure of 0.2% might support that.
Soft Data, Hard Choices
A few weeks ago, everybody was fretting about deflation. Now they reckon they can see early inflationary signs, which could accelerate as last year’s sharp drop in the oil price falls out of the figures.
Long-dated German, US and UK government bond prices have fallen by 15%, 7% and 5% respectively over the last month, a signal that inflation expectations are on the rise.
Markets now expect UK inflation to average 2.6% over the next five years, up from 2.2% in January.
US consumer prices rose in both February and March. Although only by 0.2% each time.
Given shaky recoveries and slow wage growth, I don’t expect a sudden blast of inflation.
Bubble And Crash?
Both the FTSE 100 and Dow Jones are slightly below their recent record highs of 7,104 and 18,289 respectively.
Few would argue that the FTSE 100 is excessively overvalued, trading at 16 times earnings, only slightly above its long-term average of 15. That compares to 27 times earnings in December 1999, last time it traded at these levels.
And the index looks attractive in a time of record low interest rates, yielding 3% against 2% on 10-year gilts.
This is hardly bubble territory.
Questions, Questions
The first US rate hike will be a blow for bond investors, and emerging market economies with dollar-denominated debts, notably Turkey, Russia and Brazil. Although many will have had time to hedge their position.
It could bring the type of volatility we have seen in the bond, currency and commodity markets to stock markets.
But the pace of rate hikes is likely to be slow, and I would expect the damage to be limited. Cyclical sectors such as financial, energy and technology could even benefit from rising interest rates, although utilities could suffer.
We will soon know the answer to the Fed’s big question. Make sure you’re ready for it.