“Don’t fight the Fed” - Martin Zweig
Amidst firming economic data and further improvements in the labour market, the Federal Reserve raised interest rates for the third time in this business cycle. Both central bankers and markets are expecting more of the same ahead. This week, we look how different asset classes have historically reacted in a rising rate environment.
Theory suggests that a company’s stock price (and therefore that of the equity market) should encompass all of the discounted future profits that this company will generate. All else being constant, a rise in interest rates (effectively part of the discount rate for those future cash flows), should result in lower stock prices. However, as is often the case, reality is somewhat less formulaic.
For a start, interest rates tend to rise when the prospects for economic growth and inflation, and therefore corporate profits, are improving. Looking at S&P 500 returns since 1954, it seems that most of the time, rising growth expectations have tended to dominate the negative effect of higher discount rates during rate hike cycles – valuation multiples can contract, but higher earnings have been more than enough to compensate investors.
This is obviously not true of all corners of the equity market equally. The aforementioned offset is less for those businesses with less cyclical skin in the game such as regulated utilities for example. Many argue that real estate investment trusts (REITs) – publicly traded companies that invest directly in real estate and related assets – should fall into this category, with their high and stable dividend payout ratios making them less attractive to investors when yields are rising.
In reality, the correlation between REIT returns and interest rates has been negligible, while that to equity markets has been high. The rising property demand that tends to accompany a stronger economy may better explain REIT returns rather than the interest rate cycle.
Commodities have also tended to do well in rising interest rate environments, with the attendant economic backdrop again the key factor. Much like equities though, this should not be true of all areas of the commodity complex. The perceived safe haven properties of precious metals often leave them suffering when the economic backdrop is brightening. Interesting then that history seems to point to gold performing surprisingly well in some past rising interest rate environments.
Inflation may hold the answer to this apparent contradiction. Gold’s ill-deserved reputation as a consistent inflation hedge has nonetheless seen it outperforming the wider commodity benchmark in rate hike cycles characterised by high inflation, such as the stagflationary period of the 1970s.
Similar to equities, the price of a bond should simply constitute the discounted value of all of its expected future coupon payments and the repayment of principal. The crucial difference is that a bond’s coupon payments are usually fixed and therefore do not respond to the cyclical backdrop like corporate profits, with the asset classes’ poor performance in past rate hike cycles paying testament to this relative disadvantage.
There are mitigating strategies, with investors often sheltering in shorter maturity or higher coupon issues in order to shield themselves from the interest rate or duration risk. However, while shorter duration bonds dutifully outperformed their longer duration counterparts during the rate hike cycles of 1994-95 and 1998-00, the opposite happened in the last cycle of 2004-06. This was the famous ‘Greenspan conundrum’, where a confluence of factors, specific to the time, rendered long-term yields unresponsive to the Fed’s actions. Therefore, the higher yields on longer maturity bonds were more than enough to compensate for the limited capital gains losses amidst rising short end interest rates.
Simply knowing that we are in a rate hike cycle doesn't mean that we can outperform our benchmark – we need to correctly forecast the reaction of long-term yields to rate increases as well. Key to this for this cycle will be decisions the Federal Reserve makes in coming years with regards to unwinding its balance sheet exposure to Treasury bonds.
Growth prospects are picking up and core inflation seems to be on a durably upward trajectory, but one that is unlikely to alarm central bankers just yet. If this remains the case, a relatively shallow and unhurried rate rising cycle and a very gradual unwinding of the Federal Reserve’s balance sheet, should be on the cards. All this should provide the appropriate context for stocks to continue to outperform bonds, the more cyclical areas of the commodity complex to outperform those perceived safe havens, and a modest underweight duration position within the government bond complex to be rewarded. We are currently positioned for such a cycle in portfolios.
However, while the study of history can help inform the broad contours of our investment thinking, an acknowledgement of the profound differences that have characterised this (and every) economic cycle, alongside that ever unknowable future, continues to argue for keeping an open mind and retaining a degree of investment agility in the quarters and years ahead.
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