Several considerations are worth noting.
Firstly, rising interest rates from a low base are not normally initially bad for shares as they go hand in hand with improving economic conditions. (Just like falling interest rates in a recession are not initially good for shares, as occurred last year.) This was evident for example during the initial stages of monetary tightening in the late 1970s/early 1980s, the 1984 tightening, through 1988 and through much of the 2002 to 2008 tightening.
Secondly, rising interest rates are only really a major problem for shares when rates reach onerous levels contributing to an economic downturn, eg in 1981-early 1982, late 1989 and in late 2007-early 2008. They are also a problem when rate hikes are aggressive as in 1994 when the cash rate was increased from 4.75% to 7.5% in just four months.
This is consistent with a typical investment cycle which sees rising interest rates only start to become a serious problem for shares when they reach high levels, ie well above normal levels and above long-term bond yields, and inflation is rising.
Finally, given the high short-term correlation between Australian shares (and indeed most sharemarkets) and US shares, what the Fed does is arguably far more important than local interest rates.
So in terms of the current situation while the initial move to raise interest rates may create some jitters, it’s unlikely to be enough to derail the cyclical bull market in shares:
The key risk would be if central banks move too early and too aggressively to reverse monetary stimulus much as occurred with economic policy during the 1930s in the US and in Japan in the 1990s. This is certainly a risk, but policy makers seem more than aware of the risks of a 1930’s style premature tightening – as evident by the commitment by policy makers at last weekend’s G20 Finance Ministers meeting to maintain stimulus.
The Australian dollar is already up sharply from its $US0.60 low last year. With the already wide interest rate differential between Australia and the US set to widen further and commodity prices likely to see more upside, the upwards pressure on the $A is likely to intensify. Another go at parity against the $US is likely in the next 12 to 18 months. Against this backdrop there is a strong case for investors to maintain a high exposure to fully hedged international equities, as opposed to unhedged international equities which will be adversely affected if as we expect the $A continues to rise.
The commencement of an interest rate tightening cycle in Australia and later on in other countries may cause some jitters in share markets. However, initial moves will be gradual and interest rates will still be very low for some time and with inflationary pressures very benign it will probably take several years for interest rates to reach levels that are restrictive enough to hurt the economic outlook and hence shares.
Shane Oliver is head of investment strategy and chief economist at AMP Capital Investors.
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