Investors remain concerned about the potential impact of higher interest rates on stocks. In their most recently released minutes, the Federal Reserve Open Markets Committee indicated the US economy is on solid footing and the economic conditions warrant continued gradual increasing of interest rates. This set off a sale in the stock and bond markets as investors began pricing in a fourth interest rate hike for 2018 (although the Fed had guided for three hikes this year). To a business, interest rates are the cost of borrowing money. The higher the cost, the less incentive to reinvest and expand for future growth, the slower the economy will grow. Also, higher interest rates make the yield on bonds more attractive and makes fixed income a competitive investment alternative to stocks. Holding cash and CDs may once again become acceptable. However, when looking at the historical levels of interest rates and the returns of the S&P 500, despite current fears in the market indicated by increased volatility, in the past stocks have risen during periods of rising rates.
Putting Things in Context
Chart #1 shows the Fed Funds Rate (cost to borrow money) since 1954. During the late 1970’s and early 1980’s, Fed Chair Volcker threw the kitchen sink at the economy by raising interest rates to 20% to prevent runaway inflation. Fast forward to the post Dot Com bubble burst, Fed Chairman Greenspan held rates low toward 1% to help the US economy get out of a nasty recession. The unprecedented actions by the Fed in 2008 to save the economy need no further walk down a painful memory lane.
Chart #1. Fed Funds Rate Since 1954: http://www.macrotrends.net/2015/fed-funds-rate-historical-chart
Chart #2 shows the annualized total return of the S&P 500 since 1954. Amazingly, even as Volcker was cranking up interest rates from 8% to 20% from 1979-1982, stocks posted just one negative year, 1981. From 2004-2006 the Fed raised rates from 1% to 5% and stocks finished up: 10.7% in 2004, 4.8% in 2005 and 15.6% in 2006. Interest rates went up 400 basis points over a two-year period and stocks produced an average annual total return of 10.4%!
Chart #2 Source: https://ycharts.com/indicators/sandp_500_total_return_annual
Investor’s fears are that the stock market has priced in too much good news over the past couple of years. That the timing of tax reform will only add fuel to the inflationary fire. That the Fed, which has adjusted its “dot plot” numerous times over the past five years, is way behind the eight ball and will have to raise interest rates meaningfully sooner rather than later.
In 2017 the S&P 500 finished every month in positive territory. This is very unusual. The risk created was complacency. Investors fell asleep and loosened the screws on their risk tolerance. The volatility shock in February poured a bucket of cold water on them. Volatility is healthy. It forces investors to remain disciplined to their risk level.
Those concerned with rising interest rates should focus on the fact that the US economy is not close to recession. Corporate earnings posted a tremendous quarter with nearly 77% of the companies in the S&P 500 beating Wall Street analyst expectations. The banking sector remains healthy and well capitalized. The cost to borrow money although rising, is still cheap, and supportive of growth. We do expect the Fed to raise interest rates. As long as they are able to do so in a gradual manner that is well telegraphed to the market, stocks will continue to be the best place to invest. As for volatility, get used to it, it’s back!!!!
Where Have All of the Income Investors Gone?
Since the start of this low yield environment, investors, specifically retirees, have been tripping over themselves to find bond-like stocks: Low volatility stocks with a high and growing dividend. Up until recently, investors could not get enough of Utilities, Telecom and REITs. With the US 10 year Treasury near 3%, investors have turned their backs on this group so fast that they are now very compelling values; specifically, the REIT sector which has been the worst performing year to date. If inflation is percolating, hard assets like real estate should do well.
Note: John J. Petrides, MBA, is a Managing Director and Portfolio Manager at Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Ave., Summit.
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