The Federal Reserve has been implementing a near-zero interest rate policy for nearly six and a half years. Extraordinarily low interest rates, combined with several rounds of quantitative easing, helped pull the economy out of the depths of the financial crisis. This unprecedented strategy was successful and is now being used as a blueprint in the eurozone and Japan to help spur their economies along.
Three questions remain:
— When will the Federal Open Market Committee (FOMC) begin to hike the federal funds rate?
— How quickly will subsequent rate increases come?
— What impact will this have on various asset classes?
Some of the equity and bond market volatility seen in 2015 has resulted from speculation on rates. One indication comes from fed funds futures, which can be used to gauge sentiment about the actions of the FOMC. CME Group Fed Watch extrapolates fed funds futures pricing into implied probability bands for interest rate hikes. As of mid-August, December 2015 futures show a 46.9 percent chance that the fed funds rate will increase by 0.25 percent or more by the Dec. 16 meeting date.
While some volatility may surround an announcement, it is quite likely that the FOMC will raise the fed funds rate by 25 basis points before the end of the year, and that this move is currently discounted into equity and fixed income pricing. There are multiple reasons why this will probably occur:
— The unemployment rate is at a seven-year low of 5.1 percent.
— The personal consumption expenditures price index, the Fed’s preferred inflation measure, increased 0.2 percent in May alone on a year-over-year basis. This would indicate that inflation, excluding food and energy, has crossed the 2 percent threshold, although June and July showed slightly weaker growth.
— The Fed would like to put some space between its policy rate and zero to have some room to maneuver in the case of a macro-driven financial crisis.
— During her most recent testimony before Congress, Fed chair Janet Yellen stated, “We are close to where we want to be, and we now think the economy cannot only tolerate but needs higher interest rates.”
The next series of interest rate increases should be measured and thoughtful. We have never been in a zero-rate policy period for so long. We have never embarked on quantitative easing programs before. As a result of these unprecedented policy decisions, we have seen multiple unintended consequences in the capital markets. The FOMC will likely feel its way through this slowly and deliberately. One must ask, “What are the possible unintended consequences of unwinding these unprecedented policy decisions?” How might this impact the capital markets?
Equities. Monetary and fiscal policies have had a profound impact on the U.S. equity market over the past six years. Domestic equities have tripled since their March 2009 lows. The total capitalization of the Standard & Poor’s 500 index has grown from roughly $6 trillion to $19 trillion today. Earnings doubled during that period from $417 billion to $1.04 trillion in 2014. During that time, the Federal Reserve Balance sheet has ballooned from $1 trillion to $4.5 trillion. One should assume that a large portion of quantitative easing-created capital went into financial assets, pushing stock prices up and pushing yields on fixed income instruments lower.
Where does the domestic equity market go from here after the end of quantitative easing and a zero-interest-rate policy?
The current perception is that interest rate hikes are bad for equity markets. This is not necessarily true. There have been six initial rate hikes since May 1983. The average return of the S&P 500 Index 500 days after the initial hike was 14.4 percent. We have to remember that many of these rate hikes began at higher interest rate levels than exist today. There is plenty of cushion before higher rates begin to impact equities.
While we are now in the midst of a correction, equity valuations are not stretched. The earnings yield on the S&P 500 (index earnings divided by the price of the index) is 5.5 percent, based on 2015 earnings estimates, nearly identical to where it was when the market bottomed in 2009. These compare favorably with the 10-year Treasury yield of 2.2 percent and the yield on cash at close to zero percent. Dividends and share repurchases totaled approximately $900 billion in 2014 and are on track to exceed $1 trillion in 2015. Merger and acquisition activity has picked up markedly this year. Many of these transactions are accretive to shareholders.
With the punch bowl removed, further advances in equity prices will have to be driven by earnings. While the stronger dollar has provided headwinds for multinational corporations, some offset will be found in lower input prices from basic materials and the decline in energy prices. Productivity gains continue and wage growth remains muted. The investment committee at Massey Quick remains constructive on U.S. equities for the next three to five years and is in the process of adding to high-quality domestic equities as the markets pull back.
Fixed income. With interest rates at a generational low and credit spreads extremely tight it seemed prudent to keep duration short and credit quality high. One must remember the Fed only controls the short end of the yield curve. Market participants control the rates on longer dated instruments. At Massey Quick, our best guess is that in the early days of Fed hikes the yield curve will likely flatten. Steepening will occur when we see an acceleration in inflation — both consumer prices and wages.
Massey Quick remains concerned about the liquidity in the fixed income markets. As we saw for a brief period in the fourth quarter of 2014 when everyone wants or needs to get out, bids disappear. It is also concerning that many investors have chased yield in some instruments they don’t fully understand. Much of this capital is in daily demand instruments, primarily exchange-traded funds and mutual funds. It is possible we may see a longer term repeat of the fourth quarter of 2014, particularly in areas like high yield and fixed-rate preferred if everyone heads for the exit at the same time. Because of regulatory reform traditional market makers cannot dedicate the same amount of proprietary capital to help maintain orderly markets. It could very well be that those with cash and the ability to maneuver, primarily hedge funds, and private equity managers, will be the ultimate beneficiaries of these dislocations.
Alternative investments. During the quantitative easing-driven rally in equities for the past four to five years, hedge fund returns were disappointing on a relative basis to long-only equities. Very few funds lost money, but the opportunity cost was hard to stomach. With the United States serving as the risk market of choice for global investors through the end of 2014, an immense amount of “risk on” money flowed into equity index funds. This made stock picking in general very difficult as the distinction between strong and weak fundamentals within specific companies and sectors was quite narrow. Performance turned on a dime in January of 2015. As of June 30, the HFN Fund Aggregate index (a representation of all strategies) was up 3.23 percent and the HFN Equity Hedge Index was up 5.12 percent. This compares to performance of 2.6 percent for the S&P 500 Total Return Index. Six months doesn’t represent a trend, but it does begin to validate the asset class in a post-QE environment.
Massey Quick still believes alternatives should be an aspect of portfolio construction. As we learned in 2008, they can perform an important role during market dislocations. They should be viewed as an “insurance premium” that hopefully pays the investor a positive return over a market cycle.
Bottom line. Investors should not be afraid when the Fed initiates its first interest rate hike in more than nine years. Our economy and capital markets have been though them many times before and weathered the storm. As always, asset allocation and periodic rebalancing remain the most important ingredients to investment success.
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How Interest Rate Hikes Should Influence Your Portfolio originally appeared on usnews.com