U.S. Equity Markets: Hot or Cold?

Anyone watching the stock market over the last few weeks could be forgiven for thinking Wall Street has gone mad. Are stocks the genteel Dr. Jekyll or the corrosive Mr. Hyde? The short answer has been a bit of both.

The start of the latest bout of volatility was a very strong U.S. jobs report. Wait, good news caused the markets to throw a fit? Strangely enough, yes. With the economy creating almost 300,000 jobs last month, investors began to increasingly fear that the Federal Reserve would feel confident enough in the strength of the U.S. economic recovery to begin raising interest rates. 

So the economy is getting better and the Federal Reserve wants to raise interest rates. Wouldn't that be good for stocks? Yes…and it depends.

Overall, good news is still good news. A rising tide will continue to lift many boats, even some leaky ones. But rising interest rates affect different industries in different ways, some for the better and some for worse.

If you’re a bank that makes money from borrowing at one interest rate and lending at another, low interest rates have been putting a dent in your profits for years and rising rates are a welcome sight.  However, if you’re a capital intensive business that takes advantage of a low rate environment by borrowing huge sums of money to expand capacity, then rising rates means a higher loan payment in the near future.   Not so good.

Rising rates also affect the value of income producing assets in general, regardless of the industry they’re in. For example, if you were thinking about purchasing an apartment to rent out that produces a steady $10,000 a year in income, you might be willing to pay $200,000 for it, which would give you a return of 5%. In today’s zero interest rate environment, no one would turn their nose up at a low-risk 5% return. But if interest rates rose a few percentage points so that a risk-free treasury bond yields 5% and you can’t raise the rent, the apartment’s yield no longer looks so attractive. And if you wanted to sell the apartment you’d probably have to drop the price so that the current yield is well above the risk-free rate to attract a buyer. So a rise in interest rates didn't affect your monthly rent, but it nonetheless affected the value of your asset.

When you apply this type of analysis to stocks and bonds, you can see why a little interest rate hike could rock the boat. High-yielding stocks in industries like utilities, telecommunications and tobacco, just to name a few, have been volatile in recent weeks for this very reason.

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There are a couple of things to keep in mind, though.  The odds of treasuries yielding 5% any time in the near future is very low, and the Federal Reserve is unlikely to ratchet up rates quickly or dramatically anytime soon. For these reasons, coupled with ever-increasing global demand for the yield these companies produce, we believe holding most of these positions for the long term remains a good idea. A small rate increase affects investor perceptions of these companies much more than it affects the companies themselves.

Federal Reserve Chairwoman Janet Yellen is under an intense, global spotlight.  The latest market obsession has been over the use of the word “patient” in Federal Reserve statements about the timeline of rate increases. Reading tea leaves has never been more popular. But with the values of almost all assets affected by interest rates, it’s understandable why so many are so obsessive about analyzing her comments.

The Federal Reserve, by our estimation, would like to raise interest rates in the near future to signal to investors that the economy is returning to a more normal environment and to corporations that the free-money days are winding down, which is a strong positive. The most likely rate increase is a very small one, maybe around 0.25%, or one quarter of one percent. Obviously no one will go broke by tacking on 0.25% to a loan, but with the target rate between 0.00% and 0.25% you can see it is a measured increase.

However, we believe that the Federal Reserve will be very cautious in raising rates even a paltry 0.25% for a number of reasons. 

For one, the rest of the global economy is moving in the exact opposite direction. China just lowered rates. The Bank of Japan’s interest rate is at exactly 0.00%. The European Central Bank just lowered interest rates into negative territory (yes, you read that correctly).  It will be difficult for the U.S. to stray too far from the pack, regardless of the strength of the domestic recovery. The impact of other central bank policies on U.S. policy cannot be overstated. In fact, according to her most recent schedule, Ms. Yellen’s third most time consuming activity is meeting with foreign officials, presumably to coordinate policy plans.

Additionally, the continued strength of the U.S. dollar has increasingly acted as a de facto rate hike, slowing down international profits for U.S. companies. In this context, a rapid and substantial rate hike is hard to imagine.

One thing that we believe the market is not weighing heavily enough are the benefits of U.S. currency strength and a possible interest rate hike. If you’re an investor in Paris or Tokyo, you can leave your savings in a currency that is weakening (which erodes your purchasing power) and in a bank that either yields absolutely nothing or actually costs you money (negative interest rates). Or, you can move your savings to a bank that yields something in the most stable country in the world (the United States), with an appreciating currency (which grows your purchasing power). Not a tough decision, right? We believe international investors will continue to bring capital to the U.S. in the coming months and years for safety and growing yield. It won’t power the ship, but it will be a nice tailwind.

What will the markets do in the short term in response to the potential of a small interest rate increase? As an early American financier once famously said, they will “fluctuate”.  But in the long term, stocks will inevitably follow corporate profitability as they always do. And if the economy continues to improve, as we believe it will, corporations will be the main beneficiaries. So if a rise in interest rates means that things are getting better on the home front, we don’t see that as the end of the world.

Best regards,
Patrick R. McDowell, CFP®, AIF®