What a US rate rise could mean for markets

According to Benjamin Franklin “An investment in knowledge pays the best interest” but it is another American who currently dominates markets’ attentions, at least when it comes to rates of return. All eyes are on the chair of the US Federal Reserve, Janet Yellen as the central bank’s policy makers prepare themselves for meetings on 28-29 July and then 16-17 September.

The first gathering of the Federal Open Markets Committee (FOMC) is not likely to feature any actual change in interest rates, especially as Yellen gave away few clues during two public appearances this month, one in Cleveland and the other before Congress in Washington. However, in the past the Fed has tended to flag any definitive shifts in policy at the meeting before it acts, so this month’s get together could have implications for investors’ portfolios.

The Federal Funds Rate against the S&P 500 since 1971

Source: Thomson Reuters Datastream, AJ Bell Research

An analysis of seven cycles of higher rates and eight of lower ones in the USA since 1971 shows that US equities do perform better when the Fed is loosening, but the results during periods of tightening are hardly apocalyptic. Our research shows that

• During a cycle of lower rates, America’s headline S&P 500 index rises by 19.9% on average, from the first cut to the last
• During a cycle of higher interest rates, the S&P 500 rises by 10.3% on average, from the first hike to the last

US stocks do better when rates are falling but still make gains (on average) when they are rising

Source: Thomson Reuters Datastream, AJ Bell Research
* Assumes easing cycle ran beyond last rate cut and lasted until Fed stopped adding to QE, 29 October 2014

Real market downturns have come when the Fed has raised rates, valuations have been lofty and corporate earnings have disappointed badly (normally due to the onset of recession). To take these points one by one:

• US earnings momentum is not great, as aggregate corporate profits are expected to slip slightly in the second quarter, but the economy looks to be bouncing back from an awful start to the year.
• Valuations are high on some metrics, such as Professor Robert Shiller’s cyclically adjusted price earnings ratio (CAPE) and market cap to GDP but not others.
• If the Fed does raise rates it is likely to flag this in advance (unlike 1994) and take small steps, possibly one-eighth of a point rather than one quarter. It also tends to take a clutch of rate rises, not just one, to slow the market down (with the exception again of 1994, when then Fed chairman Alan Greenspan sprang a hike on the market with no warning at all).

Chair Yellen, and therefore advisers and clients, do have a balancing act and heightened volatility is possible – after all, how many Wall Street equity and bond fund brokers, traders and fund managers were around in 2004, when the last cycle of higher borrowing costs began? Probably not as many as we would like to think, but a good fund manager with plenty of experience should still be able to add value over the full term of economic, market and interest rate cycles. Volatility can be a chance to buy cheap assets (or sell expensive ones) and patient investors with long-term horizons may simply prefer to stick to those fund managers who can pick stocks with fundamentally strong competitive positions and decent valuations, rather than worry about macroeconomics. Such an approach has served Warren Buffett and shareholders in Berkshire Hathaway rather well, after all.

First move

Interest rates matter when it comes to financial markets.

• First, higher returns on cash tempt investors to keep their money in the bank, or take it out of equities so they can park it there
• Second, bond yields tend to trend higher, again persuading investors to seek higher returns from instruments which are relatively less risky than stocks
• Third, interest rates are a key part of the discounted cashflow (DCF) calculation which is fundamental to long-term equity valuations. In simple terms, the higher the rate, the lower the valuation and vice-versa.

This is particularly pertinent now since it seems as if the Federal Reserve is inching toward a first rate hike since June 2006 and first new upward cycle in 11 years. This is understandable.

• An increase in the Fed funds after seven years at a record low of 0.25% would be a further welcome step in the healing process that followed the great financial crisis of 2007-09.
• Higher returns on cash would be good news for hard-pressed savers
• Higher cash rates and (presumably) bond yields would be welcomed by insurance firms and banks
• The Fed and chair Yellen know all too well another recession will come one day and it would be better to enter it with interest rates higher than 0.25%, so it at least has a few tools in its locker

Yellen does seem to be slowly winning over the known doves on the Federal Open Markets Committee, with both William Dudley of the New York Fed and Eric Rosengren of Boston giving interviews or making statements in the past month which seemed to open the door to a rate increase. Only Minneapolis’ Naryana Kocherlakota seems vehemently opposed.

That said, Yellen continues to stress any rate hike will be data dependent. The Atlanta Fed’s GDP Now survey, which flagged the weak first quarter well before anyone else, is now forecasting 2.4% growth in the US economy for the second quarter, up from its initial estimate of 0.6%. That may focus minds, as will lower unemployment and signs of improved wage growth.

At the same time, retail sales remain soft, manufacturing sentiment surveys are patchy and corporations continue to complain about the strong dollar – and the greenback could go further if rates rise in the US and they are still going lower nearly everywhere else in the world.

Gently does it

If Yellen is to act in September, she may well flag this in July, especially as she has already announced that she will not be attending the Fed’s annual August symposium at Jackson Hole, Wyoming. If nothing is said this month then that leaves October or December before 2016 and a Presidential election year is upon us.

She will be keen to avoid a repeat of 1994 when an unannounced rate rise caused market convulsions but even then S&P 500 eventually rediscovered its poise, only peaking six years later as the US economy and tech stocks roared ahead. This example shows that other factors will influence stocks and not just interest rates, and the table below shows a full history of all seven cycles of higher borrowing costs (and returns on cash) since 1971.

Interestingly, equities do lose momentum as a rate hike draws nearer and they digest the initial moves, before finding their feet (providing valuations are not excessive and a recession does not ensue, as in 2000).

How the S&P 500 has performed before and after initial interest rate hikes

Source: Thomson Reuters Datastream, AJ Bell Research
* Assumes easing cycle ran beyond last rate cut and lasted until Fed stopped adding to QE, 29 October 2014

Admittedly, history offers no guarantee for the future and those clients who blindly put their faith in the power of the Fed’s monetary policy were not rewarded during 2000-2003 and 2007-09. The S&P 500 index fell sharply even as the central bank cut interest rates and the mantra of “Don’t Fight the Fed” came badly unstuck.

History of loosening and tightening cycles shows recent downward moves in rates did not support stocks

Source: Thomson Reuters Datastream, AJ Bell Research
* Assumes easing cycle ran beyond last rate cut and lasted until Fed stopped adding to QE, 29 October 2014

Some investors may argue that the US market has been supported by cheap money, in the form of low rates and Quantitative Easing and that without those props the economy and financial markets alike will founder. We shall see and as a final point it is worth noting how successive rate cycles have (with the modest exception of 1999-2000) started from a lower base and ended with a lower peak. This may reflect the growing debt burden and how it can only be borne with ever-more forgiving terms and this may ultimately be the reason why chair Yellen and the Fed will only move very slowly, when they start to move at all.

US rate cycles have trended toward lower starting and finishing points

Source: US Federal Reserve, AJ Bell Research

Russ Mould
AJ Bell Investment Director