The endlessly discussed, yet-to-happen but highly feared Fed interest rate hikes are likely to be far more benign than investors imagine, if market history is a guide.
So says Northern Trust Asset Management’s chief investment strategist James McDonald in a new commentary guiding the storied ultra-high-net-worth wealth management firm’s clients.
McDonald argues that barring an unexpected inflation shock or the like, the Fed’s well-orchestrated plan for rate normalization should not be overly disruptive to stock and bond markets, and indeed, can be profitably exploited through what he calls a “tightening trade.”
Looking at the five tightening cycles of the past 30 years (1986, 1988, 1994, 1999 and 2004), the Northern Trust strategist shows that that the stock market has adjusted well, following an initial adjustment, rising during the 12-month period straddling the initial hike in four of the five cycles.
The one exception was the 1988 cycle, whose negative returns McDonald attributes to the October 1987 market crash rather than the fed funds cycle per se. Higher corporate earnings generally fueled the stock market rise during these cycles.
McDonald does not foresee a rate hike for some time though, noting that the data in four key areas—unemployment, inflation, wages and capacity utilization—are in the main far from signaling Fed tightening.
“Inflation is currently well below the levels at which prior rate hikes began,” he writes; moreover, the fact that the current Fed is more concerned with growth and “the durability of the recovery” over inflation risk gives markets leeway in this area.
Unemployment data also provides cushion before acting. Even though the headline unemployment has fallen from 10% to 6.2% in the past five years, McDonald says that broader measures of unemployment and a dramatically declining labor participation rate do not suggest a need for hurry on the Fed’s part.
Ditto for wage gains—which have averaged a meager 2% for all private workers in 2014. Only capacity utilization, which McDonald views as the “least impactful” measure, shows signs of maturation (as it is approaching its 30-year median) that would warrant some attention from the Fed.
In this still weak environment, “the fed funds futures market first signals a hike in July 2015 and has the hike fully priced in by October 2015,” he writes.
As mentioned, earnings growth has tended to propel stocks higher during tightening cycles (after some level of correction occurring in the first two months of a rate hike). The asset classes that have performed best have been developed ex-U.S. equities, emerging market equities and global real estate.
More specifically, “defensive factors” — low volatility, dividend yield, quality and value — have tended to shine in rising rate environments. Being long these defensive factors and short small-cap and momentum is what McDonald refers to as the tightening trade investors should embrace.
In the current environment, McDonald would emphasize low volatility over dividend-yielding stocks, since the latter are currently expensive.
Fixed-income performance is more complex, but the key driver has been future expectations for interest rates. McDonald argues that, currently, interest rate increases are already priced into the bond market, so bonds should perform positively barring rate hikes that exceed expectations.
The Northern Trust strategist gives the example of a 10-yeaer bond yielding 2.4%, which he says can be viewed as a 5-year bond five years hence. Through that prism, “the current five-year rate of 1.63% could double over the next five years without a negative impact on the price of our original 10-year bond,” he writes.
Though positive, bond performance should still be low by historical standards, McDonald cautions, because of the low starting point of interest rates.
“However, we do not anticipate material adverse price impacts from increasing rates. In fact, we continue to believe that the rate normalization process will occur at a slower pace than the market believes,” he writes, adding that high-yield has historically outperformed in rising rate environments.
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