Top Trade Report – How to Profit from Fed Hikes
US Dollar, Gold, QBE Insurance
Markets are moving into line with our long held view that the US economy is ready for more interest rate
hikes, and is in much better shape than the pessimists would have you believe. We believe the probability of a hike this year is now 75%, with meeting-by-meeting probabilities of 10% in November and 65% in December. Our greater confidence is due to a combination of the better growth data and the swing in the presidential election race toward Secretary Clinton.
As a result, it is worth reiterating that two major areas which we believe are likely to be impacted by US Fed moves are the price of Gold and the US dollar. Given the low level of US interest rates, if the Fed continues on a path towards rate hikes in the near term, believe we will likely see weakness in the price of gold as US interest rates move higher and the US dollar strengthens.
While most stocks have pulled back on news of higher US interest rates, QBE shares have rallied in recent
weeks. QBE offers one of the only exposures in the Australian market which directly benefits from higher
US interest rates.
Trade 1: US Dollar to Strengthen
Despite both the RBA and the RBNZ cutting their respective benchmark interest rates
to new lows, both the AUD and the NZD have remained resilient. Both the RBA and the
RBNZ are well aware of the limitations of the impact they have had on their currencies.
The problem is that all Central Banks globally are trying to depress their respective
currencies and consequently the world is locked in a currency war of sorts. Australia
and New Zealand’s relatively high bond yields (compared to Japan and Europe who
have negative yields) are seen as attractive to offshore investors which buy our
currencies to purchase the bonds. This drives our currencies higher and offsets the
effects of what our Central Banks are trying to achieve. Hence the US Federal Reserve is likely to play a significant role in impacting our currencies. A hike from the Fed would in large part close the interest rate differential between the US and AU & NZ. This would likely correspond to a fall in the AUD and
NZD and address a headache for our Central Banks.
Accordingly, one of our main portfolio thematic views remains buying stocks which benefit from a falling AUD & NZD / rising USD. These include exporters and tourism facing stocks, of which we hold a number of in our portfolios across Australia & NZ.
AUD/USD:
NZD/USD:
Trade 2: Avoid/Sell Gold
The gold price continues to retrace amid speculation of near term rate hikes by the US Fed. Several funds are pulling back their allocations to gold, and over the last week US$698m has been pulled from the largest gold exchange traded fund (the SPDR Gold Shares ETF), taking the funds holding to the lowest levels since June. It appears investors are beginning to cash in gains following the gains made by gold this year (see chart below).
Gold Price (USD/Ounce)
Gold was trading near a 2 year high following the market uncertainty created by the UK’s decision to leave the Eurozone (Brexit). The latest move lower in gold has been driven by renewed optimism around the prospect of higher interest rates in the US. The gold price is highly sensitive to US interest rate expectations – as rising interest rates lift the opportunity cost of holding non-yielding gold bullion, while boosting the US dollar, in which gold is priced. We believe the next leg will be lower for gold as US
interest rates move higher – making it more “costly” for investors to hold gold. This will be a major negative influence on the price of gold, in our view. The gold price retracement is particularly concerning for gold bulls as August has generally been a strong month for gold as jewellers stock up before the Indian wedding and festive season. Further, with the expectations of rate hikes coming and no signs of
inflation in the near term, the outlook for gold looks even more bleak. As a result, we
continue to avoid gold mining stocks, and prefer to invest in the larger diversified
miners such as BHP Billiton (BHP.AX) and Rio Tinto (RIO.AX).
Trade 3: QBE.AX
While most stocks have pulled back on news of higher US interest rates, QBE shares have rallied in recent weeks. QBE offers one of the only exposures in the Australian market which directly benefits from higher US interest rates.
QBE’s shares have been under pressure, given increased competition leading to lower insurance margins and higher pay-outs over the last financial period. Furthermore, cost ratios are rising across almost all divisions of the business, and the outlook for the sector is challenging. In saying that, QBE remains on the “cheap” side in the insurance sector and we believe global interest rates (particularly in the US) will eventually rise which result in higher portfolio income from QBE. As the US Federal Reserve will
continue on its path of gradual rate hikes this year which should positively impact
QBE’s investment earnings significantly.
QBE is heavily leveraged to higher rates with the company currently holding a significant number of funds in cash and short term money (circa 20.6%), which could be reinvested into higher yielding investments as a result of higher rates. Investment income is an important part of the total revenue structure for QBE and contributes more than 60% of QBE’s operating profits. At QBE’s last investor update, approximately
86.8% of its investment portfolio was allocated to fixed income and cash, with the rest invested in ‘growth assets’. Consequently, QBE will benefit if global markets continue to perform well and interest rates rise gradually.