27-11-2015, 08:22 AM
- Nov 26 2015 at 2:15 PM
- Updated Nov 26 2015 at 4:19 PM
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by Philip Baker
There's a very good reason why sharemarket investors are getting antsy about higher interest rates in the United States. They tend to lose money when rates start to go up in the world's largest economy.
Although it has been almost a decade since the last rate hike, it's not as if tightening cycles is unusual.
Over the past 40 years there have been seven of them, on average one every 5.7 years.
History shows that on average there has been a recession in the US every six to seven years since 1947, and double-dips within eight years of big recessions like the Great Depression.
[img=620x0]http://www.afr.com/content/dam/images/g/l/8/r/p/7/image.imgtype.afrArticleInline.620x0.png/1448511003582.png[/img]AFR Graphic
SHARES GO SOUTH AS RATES GO NORTH
But the problem for equity investors and rate hikes is that on six of those seven occasions shares in the US have posted negative returns in the first year after rates have started to head north.
And Wall Street still dictates where all other sharemarkets go.
However, according to Perpetual, on six of those seven tightening cycles, shares have risen 25 per cent or more in the subsequent three years on the back of a better economy that led to higher earnings, which in turn helps dividends.
The accompanying graph shows how shares have done in the first year of a tightening cycle and then the years after.
For that reason investors should concentrate on when the second rate hike will be rather than the first, although that first one will cause a few problems when it does eventually hit.
RUDE HEALTH
That said, financial markets are showing some signs of rude health in the lead up to it.
In the past there has been all sorts of last-minute behaviour before rates rise.
For example, companies with very low or no credit ratings look to raise as much money as they can in the junk bond market, fearing they won't be able to do so once rates rise.
But right now investors are showing signs of being discerning in the junk bond market, shying away from the really bad names, but happy at a price to back the better-positioned companies.
Some experts say that it's a real sign of a healthy financial market when investors sidestep the very risky deals.
If that's so then maybe markets are in a better frame of mind heading into a rate hike than originally thought. On Thursday the major S&P ASX 200 index was up 1 per cent and helped put the index in the black for the month of November.
According to Bloomberg, the US junk bond market is open to only a few select companies, while traders are very quick to punish companies if they reveal just the slightest piece of bad news.
In the past, with rates at record lows every company would be looking to lock in cheap money.
HAVES AND HAVE NOTS
But credit spreads have widened and there seems to be a two-tiered market with the haves and the haves not.
How investors differentiate in the junk bond market where all borrowers are known to have their risks is maybe a sign of a healthy market.
Despite investors staring down the barrel of losses in the junk bond market for the first time since 2008, speculative-grade borrowers have managed so far this month to issue twice as many bonds as in October, about $US26 billion ($36 billion).
That's the busiest junk bond desks have been since May but the supply was courtesy of a number of companies that are in good shape with a bright outlook and they were willing to meet the higher yields, as much as 13 per cent, that fund managers now need to invest in them.
Despite the increase in activity this month, year-to-date issuance stands at $275 billion, down almost 22 per cent when compared to 2014.
The cost of borrowing for some of these companies is at a five-year high.