The Fed Finally Raises Rates



But Fed and other major central bank monetary accommodation to remain

Working Photo The U.S. Federal Reserve on December 16 raised its benchmark Federal funds rate for the first time since 2006, marking the start of its first monetary tightening cycle in more than a decade. A year ago, the Fed ended its unprecedented "quantitative easing" program, which quintupled the size of its balance sheet to roughly $4.5 trillion. In anticipation of Wednesday's move, market volatility has ticked up noticeably as investors sought to re-price assets in a slightly less accommodative world.

Fears capital would flow back into the United States in response to the Fed's quarter-point tightening—effectively off zero—have driven the volatility. But the shift in Fed policy has clearly been anticipated, based on the significant appreciation of the dollar since mid-2014 and the sustained strength of U.S. Treasuries—notwithstanding the rate hike expectations and even amid sales of U.S. sovereign bonds by other central banks, including the Bank of Japan and the People's Bank of China (PBOC).

Despite the Fed's shift, it should be noted that U.S. monetary policy remains extraordinarily accommodative with the target rate range now at 0.25% to 0.5%. The Fed's guidance, which is arguably more important than this highly anticipated, yet marginal rate hike, also makes clear that the world's most important central bank will remain in go-slow mode. As stated in its announcement: "Economic conditions will evolve in a manner that will warrant only gradual increases in the Federal funds rate," which "is likely to remain, for some time, below levels that are expected to prevail in the longer run." Moreover, given the widespread expectations that the Fed's "lift-off" would begin at this meeting, much has already been discounted in current asset prices, not just dollar-strengthening, as noted above, but big drops in commodities prices and emerging market assets. Lastly, while the United States is finally tightening monetary policy, the rest of the world's major central banks maintain more accommodative stances, which should help offset the impact of the Fed's hike. And, as we noted in a previous post on Fed rate normalization, were the Fed to tighten too quickly, the resulting dollar strengthening and its growth- and inflation-dampening effects would certainly prompt a reversal, or at the least a slowing in the pace of monetary tightening.

Continued monetary accommodation in the United States and elsewhere should support global growth, including in emerging markets, which have suffered significant capital outflows. The Institute of International Finance (IIF), which represents many of the world's largest financial firms, estimates $540 billion in net emerging market outflows in 2015, marking the first net flight of capital from emerging markets since 1988. The shift involved both non-resident inflows sliding to below 2008 levels as well as increasing resident outflows. "As a share of EM gross domestic product (GDP), capital inflows have fallen to about 2% from a record high of almost 8% in 2007," the IIF noted.

The main drivers behind those outflows are slowing EM growth rates of late. And while many investors have expressed legitimate concern about higher levels of EM corporate and sovereign debt in aggregate, they should remember relative debt levels within emerging markets vary sharply, and household debt overall is quite low. As with developed markets, investors need to differentiate between emerging markets, which are still generally growing at twice the pace of advanced economies.

Given faster emerging market growth and asset valuations now at their lowest levels in decades, we believe excellent opportunities exist for longer-term investors willing to take a differentiated look at select developing country stocks. That's especially true now that the Fed has finally taken its first step toward interest rate normalization, alleviating much of the uncertainty that has weighed on global markets, including emerging markets.

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