When the U.S. Federal Reserve finally lifted the key rate by a quarter point on December 16, it was arguably the most widely anticipated rate hike in U.S. monetary history. This Fed liftoff matters precisely because no other major central bank in the world has the ability to do it. This marks the end of ZIRP (zero interest rates policy) for the U.S. But every other central bank is in ZIRP or is heading in that direction:
- The European Central Bank announced additional stimulus under the QE program on December 4th
- China has reduced its benchmark 1-year lending rate six times over the last 12 months
- India has cut its benchmark repurchase rate four times over the last 12 months
This begs the question, what are the implications on Asia? This depends on how quickly other large economies, (most importantly Europe and China) can strengthen. At least gain enough stability for their central banks to get the foot off the gas pedal. Until the market sees evidence that Europe and China are no longer muddling along the bottom, we think that the U.S. dollar will continue on its appreciation path. Many economists have pointed out that in previous rising rate cycles, the U.S. dollar appreciated over the 12 months preceding the rate hike, but not necessarily for the 12 months afterwards. This cycle might be different. Since the last interest rate cycle (nine years since the last hike), China has become the world’s largest exporter and importer of goods and services. This means that now China matters more to the rest of Asia than the U.S. does.
Nevertheless, nominal rates and currencies matter because they drive global capital flows. Zero interest rates in the wealthiest nations have driven the inflows into riskier assets and countries. This is true not only for individuals, but also for corporates and institutions. Consider the simple corporate version of the “carry trade.” Two years ago, a Chinese company with an offshore subsidiary could borrow at 1.5% for five years in U.S. dollar (USD), convert the loan into the Chinese renminbi, and buy a five-year Chinese government bond yielding 4.5%, locking in at least 3% gain in a world where the renminbi was stable and appreciating. Today, this carry trade is no longer a slam dunk. The same Chinese subsidiary would now have to borrow in the U.S. at 2%, and can only get 2.8% in a five-year Chinese government bond. The less than 1% margin is not enough to offset the volatility of the renminbi in a managed floating regime. The analogous calculation is being done by investors and institutions across the world. In many cases, capital has flowed back to the USD as interest rates in the U.S. rise while their home country’s interest rates fall and currency volatilities increase. This cycle feeds on itself as volatilities increase and risk premiums rise, which in turn increases demand for safe haven assets like the USD.
This brings us back full circle to the importance of fundamentals. We are already beginning to see the green sprouts in Europe and Asia that both economies are bouncing around cyclical bottoms. In Europe, monetary indicators continue to improve. Car sales, which can point to the health of the underlying economy, accelerated to +14% yearover-year growth in November, and Purchasing Managers’ Index data suggests that fourth Matthews Asia Perspective: Why the Fed Liftoff Matters December 2015 2 MATTHEWS ASIA PERSPECTIVE BY066_0815 quarter GDP growth in the eurozone should increase as well. Spain and Italy, for example, have decidedly turned. Spain’s real GDP grew by 3.4% year-over-year in the third quarter, and Italy’s real GDP actually grew this year after three consecutive years of contraction.
China continues to be a tale of two cities—consumption and services are vibrant, but fixed asset investment is weak and inventories remain high. For example, tolls from passenger vehicles are up double digits while commercial vehicles are down single digits. There has been a reacceleration in government spending on “soft” infrastructure, as the Communist Party responds to worsening pollution and slower economic growth by boosting investment in the social safety net, while investment in “hard” infrastructure such as bridges and roads decelerates a bit. This bodes well for companies engaged in goods and services, but not so much for producers of hard commodities exporting to China.
With the zero-interest rate era in the U.S. now officially behind us, the entire global economy is wading into uncharted waters. Looking forward, we expect markets to be characterized by higher volatility than we’ve grown accustomed to in recent years. In environments like this, we think investors should think twice before blindly investing in indices. As dispersion increases, we think it makes sense to invest with managers with high active share and an emphasis on fundamentals.
Teresa Kong, CFA
Disclosure and Notes
The views and information discussed are as of the date of publication, are subject to change and may not reflect the writer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. Active share is no guarantee of future performance and should not be used as the sole measure for an investment decision. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation, but no representation or warranty (express or implied) is made as to the accuracy or completeness of any of this information. Matthews International Capital Management, LLC (“Matthews Asia”) does not accept any liability for losses either direct or consequential caused by the use of this information.