In a speech by Janet Yellen last week to the surprise of the market she set out the case for an increase in interest rates at the next policy meeting on March 15. The key question for investors is whether this is a Fed interest rate increase that reinforces confidence in the economic recovery or one that tips the economy into a tailspin into recession. Put simply caution is warranted. This could just be the end of this period excessive returns in risk assets such as equities.
For the moment it feels that the markets want to believe in the positive view. Mutual fund flows into equities have accelerated in recent months reversing at least some of the significant outflows seen over the past two years. Last week’s IPO of Snap that brought a 50% premium within days of its launch only underlined the exuberance at present.
However we would caution investors. Many of the long term valuation metrics for equities are screaming sell. The Shiller cyclically adjusted PE multiple (CAPE) has rarely been so high and typically signals that equity returns will be negative over the medium term.
We are also sceptical that the global economy can withstand a move higher in dollar interest rates. It will either precipitate a further move higher in the dollar creating inflation for non dollar counties and/or it will significantly hurt borrowers who have been used to near zero interest rates.
Much will depend on the statement that the Fed makes with the increase in interest rates. If the Fed signals that there is still a strong likelihood of many more increases in interest rates through the balance of the year, the markets may start to see trouble ahead.