Currency investors have been betting on this outcome, with the US dollar index hitting a 12-year high earlier this month and the yield differential between two-year government bonds in Germany and the US approaching their highest level in a decade. This also reflects the fact that the US economic recovery has hit escape velocity and no longer warrants the ultra-low interest rates that have nursed it back to a rude state of health. US jobs figures have smashed expectations in recent months, unemployment is low and falling, consumer sentiment remains upbeat (consumer spending increased by 3 per cent in the third quarter) and house prices are rising again, too.
Moreover, with economists predicting that US consumer price inflation (CPI) will rise to the US Federal Reserve's target rate of 2 per cent by the end of 2016, then tightening is overdue especially as the substantial falls in energy and food prices since the autumn of 2014 have not just buoyed the US economic recovery, but have masked a potential inflationary problem down the road. In the circumstances, it's hardly a surprise that investors have been betting on a normalisation of interest rates in the world's largest economy. And that includes equity investors as the S&P 500 is close to record highs, a reflection that corporate profits can be valued highly in an environment where normalised interest rates are likely to be much lower than they were prior to the 2008 global financial crisis.
Of course, any tightening of monetary policy by the Federal Reserve is the polar opposite of the policies being adopted by the other three main central banks: The People's Bank of China, European Central Bank (ECB) and The Bank of Japan (see box opposite). Indeed, at its meeting a fortnight ago the ECB actually extended the term of its €1.1 trillion (£800bn) quantitative easing programme beyond the original September 2016 end date to March 2017, or beyond, implying that it will buy a further €360bn of government bonds. The ECB will also reinvest its portfolio of bond purchases when they mature and cut the interest rate on deposits parked by institutions at the bank to minus 0.3 per cent.
Admittedly, the largesse of the ECB fell short of what market watchers had predicted, but its actions are hardly trivial and reflect a strong determination to tackle the twin headwinds of low inflation and weak growth in the region. Core inflation in the year to date is barely positive and only predicted by the ECB's economists to hit 1 per cent by the end of 2016, way below the 2 per cent target rate.
So what are the implications of the marked divergence of US and eurozone monetary policy?
Implications of the 'Great Divergence'
Firstly, it's not just supportive of US dollar bulls, but of European equities, too. That's because companies in the region are benefiting from a significant currency tailwind to drive export growth, ultra low borrowing costs to support investment and cheap oil. Having emerged from the recession in a far leaner shape, the operational gearing of companies is higher, too, so profits can be expected to pick up more quickly as economies across the region recover. These factors are supportive of eurozone equities, which are trading on 14.8 times forward earnings, offer a 3.3 per cent dividend yield and are rated on a price-to-book value ratio of 1.6 times based on the Dow Jones Euro Stoxx 50 index.
At the same time, there is a marked divergence in valuations: whereas US corporate profits are now 27 per cent above their 2007 peak, and the S&P 500 is close to record highs, in the eurozone profits are a fifth below that high point and stock markets have yet to gain those all-time highs, either. The gap between the two has rarely been wider, according to strategists at investment bank UBS. In fact, the cyclically adjusted PE ratio for European equities is at depressed levels associated with past recessions, a valuation that will in hindsight most likely prove to be too conservative if the ECB's magic works. I wouldn't discount that possibility because with broad M3 money supply rising strongly across the eurozone, and heading towards a double-digit growth rate in Germany, then the monetary stimulus is clearly working its way through the transmission mechanism. The risk to economic growth and earnings surprises looks to the upside to me, as does relative outperformance of European equities over those in the US. It should be good news for the UK economy, too, given its major trading links with both Europe and the US. Not that an interest rate hike is likely in the UK any time soon; the futures market suggests the Bank of England will hold fire on interest rates until autumn 2016 at the earliest.
Of course, the elephant in the room is China, and the lack of credibility of the authorities there. For example, this year's economic slowdown was exacerbated by a self-imposed budget and liquidity squeeze caused by its leaders' bungled attempt to rebalance the economy away from exports and investment towards domestic consumption. The subsequent unexpected lowering of the renminbi-US dollar peg was badly handled, too, as was this summer's chaotic intervention in equity markets.
Bearing this in mind, there are important signs that the economy actually troughed out in early summer. For example, the Caixin composite index of manufacturing and services has returned to trend growth, the Caixin purchasing managers' index of factory output surged in October, and credit growth is rising at its fastest rate since 2011. All these factors are supportive of an uptick in economic activity, something worth noting for equity investors fearing another China-induced external shock to western markets.
Moreover, another slump in the world's second-largest economy seems unlikely given that the People's Bank of China has cut its one-year lending rate no fewer than six times in little over a year, and local bond markets have been opened up to local government, in stark contrast to the start of this year when they were banned from borrowing, which accentuated the fiscal squeeze. Expect further stimulus, too - both monetary and fiscal - in the months ahead, moves that would be supportive of the Chinese economy and western equity markets.
In search of Far Eastern profits
As the US central bank is set to embark on raising the Fed funds rate for the first time since June 2006, its Japanese counterpart continues to pursue ultra-easy monetary policies in an attempt to boost economic activity.
In fact, having stepped up its quantitative easing (QE) programme 14 months ago, the Bank of Japan has been buying up Japanese government bonds at the eye-watering rate of Y80 trillion (£432bn) a year, an amount greater than the total purchases of gilts by the Bank of England under all of its QE programmes. This massive bond buying programme explains why 10-year Japanese bonds offer a minuscule yield of 0.33 per cent, or less than a fifth of the return earned on the UK equivalent gilt. In effect, the central bank has been buying up all the long-dated bond issuance by the government.
The problem is that the fiscal and structural reforms that formed part of prime minister Shinzo Abe's three-prong approach to stimulate the domestic economy have failed to match the largesse offered by Bank of Japan governor Haruhiko Kuroda. In fact, the country has only averaged GDP growth of 0.2 per cent over the past two quarters and attempts to generate much-needed inflation have hardly been a roaring success: core inflation is running at minus 0.1 per cent, way off the 2 per cent target rate. Of course, cyclical factors such as the Chinese economic slowdown and the worldwide fall in energy and oil prices are beyond its control, but even after stripping out these constituents of the inflation index, the core measure is still only 1.2 per cent. And this is why some economists are predicting that the central bank will step up its QE programmes once again in the coming months.
That's worth bearing in mind because the natural consequence of any increase in money printing will be further weakness in the Japanese yen. Since the government announced its Abenomics stimulus programme at the end of 2012, the currency has lost half its value against the US dollar. In turn, this ongoing devaluation has given an almighty boost to the earnings of the country's multinational exporters. So we have the strange situation of corporate Japan reporting record profits, buoyed by export earnings, even though the economy is producing lacklustre growth.
Another consequence of the central bank's action of driving down bond yields is to force investors up the risk curve in search of yield. It's working as the Nikkei 225 index has doubled in the past three years and Japanese retail investors have been buying into the story, too. Investments in Japanese Isas have soared this year and new subscriptions into Nomura's Nikkei 225 Leveraged Index ETF, the largest leveraged ETF in the world, doubled between May and October.
So, with further currency weakness likely as the interest rate differential between the US dollar and yen widens on the back of a tightening of US monetary policy, and the MSCI Japan index trading on 14.3 times forward earnings after factoring in EPS growth of almost 13 per cent for the coming year, the sun has yet to set on the recovery in Japanese equities.
■ For a limited period and strictly subject to stock availability, Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com at a special promotional price of £11.99, plus £2.95 postage and packaging, or by telephoning YPDBooks on 01904 431 213 to place an order. It is being sold through no other source. Simon has published an article outlining the content: 'Secrets to successful stockpicking'
