Portfolios need more virtues than just patience

The financial markets continue to digest the implications of the policy meeting of the US Federal Reserve (18 March), which saw chair Janet Yellen drop the word “patience” from the central bank's carefully crafted outlook statement. Fed-watchers interpreted this to mean Yellen would not be sanctioning an interest rate increase at either of the US monetary authority's next two meetings, slated for April and June.

The bond market has already switched its attentions to the Fed meeting scheduled for 15-16 December as the most likely source of a hike in headline borrowing costs. Even that could be wrong. Yellen left herself huge amounts of wiggle room with her commentary that any future decisions would be “data dependent”, with a particular focus on inflation, where the Fed's 2% target looks some way off.

Whether the Fed raises this year or not, the markets are already fretting over its potential impact. Highly-respected US fund manager Ray Dalio of Bridgewater Associates is warning Yellen risks a repeat of 1937’s rout of the Dow Jones Industrials and double-dip recession if she moves too quickly (even if the circumstances now are in many ways very different). Meanwhile, Albert Edwards, the (admittedly notoriously) bearish strategist at Société Générale argues interest rates are too low for the financial markets, as valuations become bubbly, yet potentially still too high for the still heavily-indebted global economy.

AJ Bell has therefore analysed all of the prior monetary policy tightening (and loosening) cycles in the US and UK, dating back to 1971. The conclusions are as follows:

  • Stock markets have performed less well during tightening cycles than they do easing ones, in both the USA and the UK
  • The traditional relationship of markets doing badly during rate hikes and well during rate cuts has however begun to break down, if events since 2004 are any guide
  • The peak in the interest rate cycle has become progressively lower since the early 1980s in the USA and late 1990s in the UK.

Stock markets on both sides of the pond have historically done less well in periods of rising interest rates

Tightening cycleS&P 500 FTSE All-Share
Average movement11.2%6.5%
   
Loosening cycleS&P 500 FTSE All-Share
Average movement27.9%26.0%
   

Source: AJ Bell Research, Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

The first point may be no surprises to advisers or clients but the second and third might be (and I must thank a Midlands-based adviser for flagging this final idea to me, though won't embarrass them by revealing their identity).

Markets are still basking in the liquidity provided by record-low interest rates and the QE schemes promoted by Japan, the EU and Sweden. They appear content with the view rates will only rise slowly, if and when they rise at all.

Yet the ongoing downward trend in the peak of rate cycles may reflect how the globe's debt burden continues to grow and therefore that the foundations of the longed-for upturn remain shaky. Advisers can therefore add value to their clients by helping to construct portfolios suited to what could prove to be a prolonged period of low growth, low inflation and meagre returns on cash. Under these circumstances, history suggests individual companies which provide (or funds which target) organic growth, strong balance sheets, pricing power and healthy cashflow to support dividends or coupons will be the most highly prized virtues, as well as patience.

Policy pickle

Stock and bond prices alike have reacted favourably to the US Federal Reserve's decision to join the Bank of England to dump “forward guidance” and switch its attentions from unemployment and jobs numbers to inflation (or the fear of deflation).

Markets have assumed this means there will be no rate rise for some time to come. Like Albert Edwards and Ray Dalio, Janet Yellen's predecessor in the Fed hot-seat, Ben Bernanke, cited 1937-38’s recession and market collapse as a reason why monetary policymakers had to be careful when it came to finally moving away from ultra-loose monetary conditions.

Equally, central banks have shown they can run policy too fast and loose for too long, with equally deleterious consequences. The UK’s then Chancellor of the Exchequer Nigel Lawson slashed interest rates following the 1987 crash, fearing it was a harbinger of an economic downturn. It proved nothing of the sort. The UK economy began to overheat and Lawson jacked up interest rates from 7.875% to nearly 15%, tipping the UK into its next recession. Low rates in the US were, in the eyes of many, the root cause of the technology stock and property bubbles which eventually popped in 2000 and 2007 respectively.

Policy error is one danger which cheap central bank money cannot price out of the markets, so advisers and clients will therefore have to keep listening to Janet Yellen, the Bank of England’s Mark Carney and other central bank luminaries whether they like or or not. AJ Bell has analysed all of the prior monetary policy tightening (and loosening) cycles in the US and UK over the past 45 years and how they relate to the S&P 500 and FTSE All Share Indices respectively.

Rate of interest

Again, three conclusions can be drawn.

  • Stock markets have performed less well during tightening cycles than they do easing ones, in both the USA and the UK. Rising returns on cash lessen the appeal of other, riskier asset classes, which look more expensive once the effect of higher rates is factored into long-term valuation tools such as Discounted Cash Flow (DCF) models.

In sum, there have been eight tightening cycles in the USA since 1971. During their course, the S&P 500 has returned 11.2% on average (in capital terms, excluding dividends). Over the course of 9 loosening cycles, the index has advanced by 27.9% on average – and that excludes the 134%  gain seen since January 2009, since when rates have stood unchanged at 0.25%.

US equities have performed better on average when interest rates have been falling

 Tightening cycle   Loosening cycle  
FromToRate increase
(points)
S+P 500
Performance
 FromToRate decrease
(points)
S+P 500
Performance
 
         
Jul-71Jun-747.50-11.1% Jan-71Jun-71-0.758.7%
Apr-76Apr-8011.2510.0% Jul-74Mar-76-6.2512.3%
Nov-80Jun-817.004.2% Apr-80Sep-80-5.508.8%
Mar-84Aug-843.44-5.3% Jul-81Feb-84-11.0022.6%
Dec-86May-893.9310.9% Sep-84Nov-86-5.5659.5%
Dec-93Jun-953.0014.6% Jun-89Jan-94-6.5644.6%
Jun-99Dec-001.7536.8% Jul-95May-99-1.25153.9%
Jun-04Aug-074.0029.8% Jan-01May-04-5.50-15.0%
     Sep-07Dec-08-5.00-44.3%
         
Average movement11.2% Average movement27.9%
         
     Jan-09Mar-15 134.4%

Source: AJ Bell Research, Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.
In the UK the FTSE All-Share has returned 6.5% on average (in capital terms, excluding dividends) during tightening cycles against an average advance of 26% when rates have been going down.

UK equities have performed better on average when interest rates have been falling

 Tightening cycle   Loosening cycle  
FromToRate increase
(points)
FTSE All-Share
Performance
 FromToRate decrease
(points)
FTSE All-Share
Performance
 
         
Jul-72Jan-748.00-30.4% Mar-71Jun-72-2.0064.2%
Jun-75Nov-752.255.7% Feb-74May-75-3.25-5.4%
May-76Dec-765.75-20.1% Dec-75Apr-76-3.009.2%
Jun-78Jul-809.5028.1% Jan-77Apr-78-8.2555.9%
Aug-84Mar-855.0023.5% Aug-80Jul-84-8.1383.7%
Jul-88Oct-907.505.0% Apr-85Jun-88-6.5054.0%
Oct-94Dec-951.5011.3% Nov-90Sep-94-9.7564.7%
Nov-96Oct-981.8116.2% Jan-96Oct-96-0.949.2%
Oct-99Feb-011.002.0% Nov-98Sep-99-2.5029.7%
Mar-04Aug-051.0021.3% Mar-01Feb-04-2.25-27.5%
Sep-06Dec-071.259.0% Sep-05Aug-06-0.2512.6%
     Jan-08Apr-09-5.25-38.4%
         
Average movement6.5% Average movement26.0%
         
     May-09Mar-15 86.7%

Source: AJ Bell Research, Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

  • The traditional relationship of markets doing badly during rate hikes and well during rate cuts has however begun to break down, if events since 2004 are any guide. Over the past four cycles, two up and two down, US stocks fell as rates were cut and (initially) rose as borrowing costs increased. Perhaps markets were simply overshooting, in response to money being made too cheap for too long, and it took a sustained period of higher borrowing costs to deflate first the technology and then the property bubbles which had formed. This may be a cautionary tale to those who believe in the omnipotence of central banks.

US stocks fell even as rates were cut during 2001-04 and 2007-08

US stocks fell even as rates were cut during 2001-04 and 2007-08

Source: AJ Bell Research, Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.
The same phenomenon can be seen in the UK, where stocks initially fell sharply despite the aggressive rate-cutting campaigns of 2001-2004 and 2008 to 2009. The central bank safety net had a hole in it.

UK stocks fell even as the Bank of England cut rates during 2001-04 and 2007-08

UK stocks fell even as the Bank of England cut rates during 2001-04 and 2007-08

Source: AJ Bell Research, Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

  • The peak in the interest rate cycle has become progressively lower since the early 1980s in the USA and late 1990s in the UK. Both of the above charts question the ultimate potency of monetary policy as a sustained fillip for equity market performance and the final one may pose a stiff challenge in the future. The peaks and troughs of UK and US interest rate cycles have declined over time, which might make advisers and clients wonder what happens next time a recession hits.

Interest rates in the UK and US seem to be on a long-term downward trend...

Interest rates in the UK and US seem to be on a long-term downward trend...

Source: AJ Bell Research, Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

...which may make policy response to the next downturn interesting

...which may make policy response to the next downturn interesting

Source: AJ Bell Research, Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term. No doubt policy wonks at our central banks will devise new monetary tools but how effective they prove remains to be seen, especially when the global economy is still battling for genuine traction after nearly seven years of record-low rates on both sides of the Atlantic.