On March 15, the Federal Open Market Committee (FOMC) announced that it was raising the target range for the federal funds rate by 25 basis points to 0.75-1.0% while predicting two more hikes this year. Read on to see what our Insight contributors see as likely to be the effects of these changes in the areas of earnings, economics, M&A, and fixed income.
Earnings for banks and other companies in the Financials sector are particularly sensitive to changes to interest rates. Given this increase marked the second rate hike in the past three months, have analysts been increasing their EPS estimates for 2017 for banks and other companies in the S&P 500 Financials sector over the past few months?
In terms of EPS estimate revisions, just over half of the companies (52%) in the S&P 500 Financials sector have seen an increase in their mean EPS estimate for 2017 since December 31. At the sub-industry level, three of the four sub-industries in the sector that have the highest percentage of companies that have recorded an increase in their mean EPS estimate for 2017 (since December 31) are bank-related sub-industries: Investment Banking & Brokerage (100%), Diversified Banks (83%), and Regional Banks (73%).
After Janet Yellen clearly telegraphed early this month that a March rate hike was likely, the announcement came in full this week. Along with the policy decision statement released on Wednesday, the FOMC released its “dot plot,” which is a graphical depiction of the policy rate predictions from each of the FOMC participants. The “dot plot” provides insight into the thinking of each of the committee members looking ahead to future policy decisions. This week’s updated “dot plot” shows that the median view (nine of 17 members) is that the target range will be 1.25-1.5% at the end of 2017. This means that the majority of the committee expects to raise rates twice more this year, assuming a 25 basis point increase each time.
Looking forward, the “dot plot” points to a fed funds rate of 2.0-2.25% at the end of 2018 and 3.0% at the end of 2019 and in the longer term. The committee noted that “monetary policy remains accommodative” and they will continue to monitor economic conditions pursuant to their dual mandate of price stability and maximum sustainable employment.
According to the CME, fed funds futures prices are predicting that the Fed will hold rates steady at their next meeting in May, but as of today, there is a 55% probability that we will see another hike in June.
Mergers and Acquisitions
Cash is king! The Fed raised rates yesterday and the M&A market is really going to feel... well, nothing really. Perhaps 20 years ago, before globalization, financial engineering, and acquisition finance took off, the M&A market may have felt a squeeze from rate movements like this that would have slowed the pace of deal-making by putting cash in check.
Today, however, the deal market is not tied to any single economic factor. An expected rate rise isn't likely to cause dealmakers to change course. Companies can shift payment methods as needed, without backing away from deals. And, besides, banks need to make loans, buyers need to fund growth, and growth comes from acquisitions.
Having said all that, outside the U.S., in emerging market economies that rely heavily on the U.S. dollar, there is a definite possibility they may feel a pinch. (For more, see Is the Dollar’s Strength the Emerging Markets’ Weakness?)
Global companies, and especially large U.S. companies, are probably already buffered from rate changes impacting their acquisition strategies. As an example, you can just look at the amount of cash on balance sheets (and in particular the amount held overseas).
Overall, the Fed's rate hike is a non-event for deals: whatever direction the M&A market is headed, it will continue un-phased.
The rise in the fed funds rate paints an optimistic picture for the U.S. and global economy. Global manufacturing is at its highest since 2011, inflation levels are reaching central banks targets, the 10-year yield is closing at levels not seen since 2014, and the labor market is approaching full employment. However, the active management space is still under pressure from a lower fee environment. The positioning of actively managed portfolios is going to be the central topic of discussion as these macro-economic factors reach levels not seen in three to six years.
Ensuring an attribution and risk system can align with how a portfolio is positioned will aid in the business development, marketing, and client reporting process. Investors are not only going to want to know how and why tactical bets were initiated but how those bets delivered them the alpha they are expecting from active management. In times like this, where there is so much macro-economic activity that active managers can take advantage of, teams should insist on a model that is fluid across different investment strategies and asset classes.