Over the last decade, “Don’t fight the Fed” has become an increasingly important mantra and a very profitable one. After raising rates 17 times between 2004 - 2006, the Fed entered easing mode and has remained there ever since.
That is, until last December, when we saw the first rate hike in over a decade. This marked a very important inflection point in financial markets that investors are only now starting to react to.
After the generational bottom in 2009, markets began an uptrend that until recently had the tailwind of an exceptionally accommodative central bank. The “Bernanke Put” remained in effect for many years and transitioned into a “Yellen Put” during the early stages of her tenure as chairwoman.
But now things have changed, and it’s important that investors recognize this and begin to monitor their portfolios accordingly.
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With the Fed on the verge of a second rate hike, and possibly more in the pipeline, “Don’t fight the Fed” now suggests that investors should be wary about positions in both stocks and bonds.
When the Fed lowers rates, it does so to stimulate the economy and drive both job creation and inflationary pressures. But when the Fed raises rates, it’s done to reign in the economy, preventing it from overheating, and to keep inflationary pressures at bay.
While this rate hike cycle is unlikely to be anything like the ones we’ve seen in the past, the lessons for investors remain very much the same. Let’s go through what will and won’t work now that the Fed has removed its foot from the accelerator, and is beginning to gradually apply the brakes.
We’ll discuss bonds first, then move on to stocks.
Bond holders have received very little compensation for years now, and many appear mildly excited at the prospect of higher rates. This excitement needs to be tempered for two reasons.
First, while higher interest rates do imply that fixed income investors can earn higher returns, this return will apply only to newly purchased bonds, not those that investors already own.
When market interest rates rise, the value of existing bonds decline. This is especially true of bond funds, which technically have no maturity and thus no way for investors to regain all of their principal. If you own bonds through a bond fund and rates continue to rise, expect those holdings to decline in value substantially.
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Investors who own actual bonds are better off because at least they can recoup their initial investment (pending no default), but rising rates will still hurt the value of those bonds in the event they must be sold before maturity.
The second reason bond investors should temper their excitement is because rate hikes may not necessarily translate into higher interest rates. Huh?
While the short end of the yield curve is typically very responsive to rate hikes, the long end of the curve isn’t. In fact, one could make the case, as I have here, that rate hikes may drive longer-term bonds yields lower, because those bonds tend to react to real GDP growth and inflation expectations, both of which decline as short-rates move higher.
Now let’s switch gears and talk about implications for equity investors.
Over the last six months, stock market action has been relatively benign, but beneath the surface, there has been a major shift taking place. That shift involves investors exiting rate sensitive areas of the market and transitioning into cyclical sectors that do better with an improving economy.
Inflection points sometimes draw lots of fanfare, and other times they come and go quietly, hardly noticed until well after the fact. You may have thought that the transition out of rate sensitive areas would have occurred leading up to the first rate hike and in its immediate aftermath, but this process takes time.
The chart below shows stock market performance by sector during the first half of the year. Notice that aside from energy, the top performing sectors are Utilities and Consumer Staples.
These two sectors have become immensely popular in recent years as investors have reached for yield. Known as “bond market equivalents,” companies in these sectors deliver reliable dividends that are enticing to investors when bond yields are so low.
These areas of the market continued to do well during the first half of the year specifically because following the first rate hike, interest rates moved lower. You can see that in this next chart below, which shows the yield on the 10-year Treasury.
The 10-year treasury yield hit an all-time low in the beginning of July, at which point it finally began to trend higher. If we look at stock market action over the last three months, we can get a pretty good idea of what’s likely to happen if long-term rates continue to move higher in the months and years ahead.
This next chart shows sector performance during the 3rd quarter. Notice the abrupt reversal that took place with Utilities and Consumer Staples subsequently became the worst performing sectors.
Not only that, financials, which are really the only sector that benefits from higher rates, began to muster up some strength.
If rates do continue to rise, expect this same rotation to continue: Financials will benefit while previously loved bond market equivalent sectors will suffer. For the record, that group contains not just Utilities and Consumer staples, but MLPs, REITS, and just about any other stable company that pays a dividend higher than Treasury yields.
With financials being the only real beneficiaries of higher rates, it begs the question, why not just sell all stocks? After all, that would certainly be the clearest manifestation of “Don’t fight the Fed” in this new environment.
The reason you probably don’t want to sell all your stocks now is because stocks are historically the best wealth generators in history. They provide the highest risk premium (compensation for bearing risk) and they tend to do just fine during the early stages of a rate hike cycle.
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If you had sold all your stocks when the Fed began raising rates in 2004, you would have missed out on tremendous gains. But … if you never sold your stocks, you would have taken a 50% haircut in the collapse that ensued.
This suggests that the time to reduce overall stock exposure will occur sometime during the middle of this rate hike cycle as the economic expansion draws to a close. In the meantime, be wary of which sectors of the market will benefit from higher rates and which will be hurt, and keep your eyes on the long end of the yield curve to see if rates truly are rising.
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