Will the US Federal Reserve raise interest rates this month and if so by how much? It is the question on everyone's lips and the answer could affect your exchange traded fund (ETF) portfolio.
Markets are waiting with bated breath for the outcome of the 16-17 September policy meeting. A rate hike has been well flagged and any rise is expected to be slow and steady. But whatever the outcome, analysts predict a period of volatility ahead.
David Liddell, CEO at IpsoFacto Investor, says: "There are a lot of people either way who will interpret what the Fed does or doesn't do badly. There is potentially a lot of short-term volatility in markets ahead."
José Garcia Zarate, ETF analyst at Morningstar, says: "This hike has been pre-announced so some of it could already be priced in but markets tend to react to the meeting anyway."
Three-month change in the S&P 500 index after first rate hike from the Fed
| Year of first rate hike from the Fed | 3-month change in S&P 500 index following first rate hike |
|---|---|
1971 | -1.5% |
| 1977 | -7.8% |
1983 | 9.9% |
| 1986 | 14.1% |
| 1994 | -3.9% |
| 1999 | -6.6% |
| 2004 | -2.3% |
Source: AJ Bell
The first place to look for that volatility is the fixed-income market. Bonds are highly affected by changes to interest rates, particularly those with long durations. ETFs tracking bond markets are likely to feel the impact and the effect is unlikely to be restrained to just one type of bond or one region.
Mr Garcia Zarate says eurozone bonds could react to the news as well as US bonds. "Eurozone bonds have been pricing in a Fed hike even though the ECB on its own is not in the mood for hiking rates any time soon. That goes to show the power of the Fed," he says.
"Even though Europe and the US are at very different stages of the economic cycle, the Fed always tends to lead, so there could well be a correlation between the two markets (as people anticipate a UK rate hike)," he says.
He adds that the influx of quantitative easing across global markets has depressed yields on long and short duration bonds, meaning long- and short-dated bonds could all be hit and it is hard to predict where the shocks will be felt most. That could mean ETFs as varied as iShares Euro Government Bond 10-15yr UCITS ETF (IBGZ) to SPDR Barclays 0-3 yr US corporate bond (SUSD).
But perhaps the key ETFs to watch are emerging markets debt and equity funds. These look set to suffer the hardest from capital outflow and dramatic currency fluctuations. The issue is a combination of these countries having borrowed large amounts of dollar-denominated debt and the fact that a rate rise typically sends US money pouring out of emerging markets and back into the US.
The last time the Fed signalled a rise in rates in 2013, an emerging markets 'taper tantrum' ensued, sending markets into a tailspin. The Fed is keen to avoid that scenario this time around and rates are set to rise more slowly. Meanwhile, many emerging markets are shielded by having issued debt in local currencies. But the effect is likely to be fairly indiscriminate at least in the short term.
"Interest rates have made it more attractive to invest in emerging markets over the past 10 years but if rates go up in the US and the dollar goes up then a fair share of investors would get out of those markets and go back to the US for a higher yield," says Mr Garcia Zarate.
Shaun Port, chief investment officer at Nutmeg, says: "Bond markets should be well prepared for this but in the short term the big area of concern is emerging markets. When you see the beginning of a rate cycle you see money flow from emerging markets. We've seen some evidence from Asia already and a Brazil downgrade.
"There are some really strong fundamentals in a few emerging markets - we like the domestic stories in India and Indonesia. But when you have a general worry about emerging markets they all get tarred with the same brush and they all suffer."
ETFs affected could include iShares JPMorgan $ Emerging Markets Bond UCITS ETF (IEMB), which offers exposure to dollar-denominated emerging markets debt, and db x-trackers MSCI Emerging Markets Index UCITS ETF 1C GBP (XMEM).
Mr Liddell says: "Traditionally, a rise in rates would be bad for gold and other commodities", while Mr Garcia Zarate says: "Gold doesn't pay any interest and it loses the safe-haven appeal during periods of hiking rates when you can get higher returns from other assets."
But Mr Liddell adds: "The price of gold might not fall if people regard this as a stress time in the markets."
A rise could also have implications for high-yielding ETFs with strong relationships to government bonds such as property ETFs. Mr Port says Nutmeg sold out of iShares UK Property UCITS ETF (IUKP) earlier in the year when yields looked to be dropping and says these ETFs could be hit.
He has also moved significantly out of the FTSE 250 index in the past week in the belief that a Fed rate hike would lead to a UK rate hike soon afterwards. He says that could impact the FTSE 250, which has been outpacing the FTSE 100 significantly in the year to date. He says: "The last time we saw a big underperformance in the 250 was when we had rate hike fears." The FTSE 250 is normally highly correlated to the S&P 600, says Mr Port, but is currently trading at valuations far above it, leading him to feel nervous about it. Nutmeg was invested via iShares FTSE 250 UCITS ETF (MIDD). Vanguard FTSE 250 UCITS ETF (VMID) also invests in the same index.
