November 2015- Many clients and friends I speak with seem to believe that the current stock market rally will end very shortly and a recession is right around the corner. We do not believe this is the case for a number of reasons.
Recessions are usually triggered when the economy overheats and the Fed raises rates too quickly. The economy is far from overheating. With inflation running between 1.6% and 1.8%, we are pretty comfortable we won’t experience rampant inflation anytime soon.
Will the Fed raise rates? If they do, will higher rates be negative for stocks?
The timing of a rate hike is of little importance, but we do feel that the economy is strong enough to raise rates. In fact we predict the Federal Reserve Board will raise rates at their December meeting.
This projected rate hike from 25 basis points to 50 basis points is almost meaningless. It is more symbolic of an economy that was sick and can now stand on its own two feet.
We’ve spent some time looking at the potential impact of rising interest rates on investor portfolios, and how markets historically have overstated the path of interest rates. Investors should not be concerned about the first rate hike. Looking at historic averages, there is plenty of time before we have to be concerned with negative growth. We continue to believe that individual stocks with good business models, management, and strong balance sheets make sense. With all things being equal, history tells us that companies with the ability to raise dividends, outperform stocks that either can’t raise or don’t pay dividends.
The takeaway: Federal Reserve (Fed) interest rate increases historically have been positive for stock prices. The data table below provided by Lord Abbett shows how different types of asset classes performed in a rising rate environment. Stocks performed well in each cycle and clearly were the best asset class to own. Note that longer maturity fixed rate bonds clearly underperform in these types of markets.
We’ve gone back and analyzed past periods of rising rates looking for why stocks have done so well. What we found was markets historically have overstated their predictions of how high rates will go, and how quickly interest rates would rise. We feel that the current projected path of rates once again overstates both the likely path and quickness. Once the investment community becomes more comfortable with this idea, they will be more optimistic about holding stocks in a relatively benign interest rate environment.
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