Dear Clients and Friends of Insight,
The Federal Reserve recently raised the Federal Funds rate, and indicated they will raise it several more times this year, potentially setting the stage for rising interest rates for many years to come. Perhaps this widely anticipated event is finally going to happen after years of expectation. There has been continual discussion among market participants about the implications of rising rates on financial markets, and many fear they will act as a constraint to the performance of both stocks and bonds.
First, let’s look at bonds. The worry is that rising interest rates will pull down the price of existing bonds so that their current yield is comparable to the now higher interest rates of newly issued bonds. Conceptually this relationship is correct, but the repricing can vary—not all bonds will move in lock-step with the rise in the fed funds rate. Some factors to consider:
- Maturity Length: Although the Fed can set the fed funds rate, which is the interest rate charged to commercial banks for overnight loans, they cannot directly control interest rates for longer borrowing periods. Thus, regardless of the Fed’s actions, interest rates for a range of maturities can rise or fall by differing amounts and percentages. Ironically, after the Fed’s first increase in December 2015, interest rates across the yield curve declined! Though interest rates have risen for all bonds recently, we expect the rates for the shortest-term bonds to increase more than those for intermediate and longer-term bonds.
- Bond Sector: Bond price changes also vary across different types of bonds such as Corporate, Treasury or Municipal. For example, municipal bonds are usually priced so their yield is less than Treasury bonds of similar maturity because the interest earned from municipal bonds is tax-free. However, municipal bonds have very different supply and demand conditions than other bonds, and over the last ten years, they have sometimes traded on par with Treasury yields, and occasionally even at a premium to them.
- Coupon amount: Bonds with coupon rates that are higher than the current interest rate (called “premium” bonds) will not decline in price as much as bonds with coupon rates that are lower than the current interest rate (“discount” bonds). Premium bonds are less sensitive to interest rate increases because of the timing and amount of the cash returned to investors.
- Credit quality: Higher quality bonds will tend to hold their value better than lower quality bonds because rising interest rates usually slow the economic expansion, sometimes even leading to a recession. Since lower quality bonds have a higher risk of defaulting when the economy slows or falls into recession, their price declines can be greater.
Most importantly, for conservative investors with a longer time horizon than that of Wall Street traders, is the following axiom: the income earned while owning bonds determines the vast majority of your return. If you hold your bonds to maturity, which is our preference, it determines your entire return.
Now, for stocks. The worries here are many. There is a very reliable indicator – “Three steps and a stumble” – that suggests that the stock market will decline substantially whenever the Federal Reserve tightens monetary policy three consecutive times, which they have now done. The current bull market is
one of the longest in history. Stock valuations are elevated based on many measurements. Add to this the current political discord and there is good reason for concern. As such, we believe it could be a bumpy few years for stock markets. Yet there are also many reasons why individual stocks could continue to reward investors in the years ahead. Here are some:
- Improving Economic Conditions: The Leading Economic Index which forecasts future economic activity is composed of ten components related to employment, production, and investment. Six of these are now strong and eight have been improving. Similar trends are emerging globally. Also, consumer and business confidence are at their highest levels for more than a decade. Earnings for S&P 500 companies are expected to grow 12% this year and next. We don’t believe a recession is likely any time soon.
- Fiscal policy: Tax reform could materially benefit corporate earnings. It is estimated that a reduction in corporate tax rates could add as much as another 14% to the S&P 500’s current earnings level. There could be a huge windfall for investors from increased reinvestment and larger dividend payments if the trillions of dollars of cash reserves overseas can be returned to the U.S. with favorable tax status. Individuals as well could find themselves with additional disposable income. Add to this a friendlier regulatory environment, and things are pretty positive for future earnings.
- Valuations: Not all stocks are expensive. In fact, there is quite a divergence. If we sort the companies in the S&P 500 by their price-earnings ratio and measure each quintile’s P/E ratio, we find that the most expensive 100 stocks trade for a rich multiple of 77x earnings! By contrast, the 100 least expensive stocks trade for only 11x earnings. We are still able to find good values in this high- priced market.
- Historical perspective: The current bull market is now eight years old and the third longest since 1928 as the S&P 500 has advanced about 250% from the lows of 2009. Looking at annualized returns for the prior 10- and 20-year periods tells a different story. The current market’s performance is well below historical average due to the sluggish recovery. For the last 10- and 20-year periods, stocks returned only about 7.5% annualized compared to an historical average of roughly 11% annualized. Further, while rising interest rates are thought to be bad for stocks, historically they have actually been positive many times. Between 1954 and 2007, during years with rising interest rates, stocks had positive returns 20 times, while logging negative returns only 11 times.
Although we have a positive longer-term outlook, both the bond market and the stock market are due for some challenging times in the year ahead. Careful portfolio management is paramount to achieving favorable results. This practice starts with maintaining an appropriate asset allocation suitable to each investor’s time horizon, liquidity, and income needs. It continues with a proven and disciplined research process to identify rewarding yet conservative securities for portfolio inclusion. We will continue to implement these prudent tenets as we serve your investment needs going forward.
INSIGHT INVESTMENT COUNSEL