With the start of the new tightening cycle, the Federal Open Market Committee ended a seven-year period of zero rates.
“This is a big event (maybe not ‘Star Wars’ big, but big) because of how long zero rates have been in place,” said LPL Financial (LPLA) Chief Investment Officer Burt White in an economic commentary piece he leased Tuesday.
Advisors and investors should view the Fed’s decision “as a vote of confidence,” according to White.
“We saw the alternative in September when the Fed surprised markets by not raising rates, citing risks overseas, and stocks fell because market participants wondered what the Fed knew that they didn’t,” he explained.
Expect bumps ahead, as rate hikes reaffirm that the economy has passed the midpoint of its current cycle, “a stage that may bring additional market volatility,” White says. “We especially anticipate it in the coming weeks and months, as investors adjust to the start of a new era of U.S. monetary policy. Historically, while stocks have risen in the year after the Fed starts hiking rates, performance has been mixed during the first three months.”
Gradually rising rates should help support stock market valuations, according to LPL’s CIO: “Stock valuations are partly a function of market interest rates, which are partly a function of the level and trajectory of the federal funds rate controlled by the Fed (growth and inflation also play key roles). Interest rates reflect the level of competition bonds provide for stocks, and a gradual pace of hikes suggests that the weak competitive threat bonds currently present for stocks is unlikely to get much stronger anytime soon.”
What Else to Expect in ’16
The start of monetary policy “normalization” does not change LPL’s stock market outlook.
“We continue to expect mid-single-digit gains for the S&P 500 (based on total returns) in 2016 and will hopefully eke out a couple more points over the remaining weeks of 2015,” White explained.
The broker-dealer’s investment team favors stocks over bonds, large-caps over small, growth over value, and domestic equities over foreign shares. Its favorite sectors are health care, industrials and technology.
As for real estate investment trusts, they look more attractive vs. the 10-year Treasury, which is yielding 2.20% “even after the Fed rate hike,” White says.
Second, U.S. hiring trends and the low unemployment rate are favorable for the sector. Plus, the U.S. has not experienced overbuilding recently, which suggests a decent supply-demand balance.
“Add to that the likely gradual pace of future rate hikes, and REITs become more appealing for suitable income-oriented investors. Still, our tactical view (which has no bias for income) remains neutral, although we could envision becoming more positive if rising interest rates create an attractive buying opportunity,” White explained.
Master limited partnerships, on the other hand are being affected by the steep decline in oil prices and news that some energy companies have reduced distributions.
“Until oil prices stabilize and investors get more clarity on the distribution outlook, we would not expect this group to be as responsive to changes in interest rates as it has been historically. As a result, we see only a marginal near-term benefit from a likely gradual pace of rate hikes [for MLPs],” the CIO said. The utilities sector tends to demonstrate “a high degree of interest rate sensitivity,” so some investors employ it as a bond substitute.
While LPL favors economically sensitive sectors, low yields from bond market alternatives and an expected modest rise in yields tied to gradual Fed tightening “may help this group hold up relatively well, despite rich valuations,” White states.
Commodities, which are not traditionally considered interest-rate sensitive, could be positively impacted, as well.
“A gradual pace of tightening may limit further upward pressure on the U.S. dollar, which may help speed up the commodities bottoming process,” he explained. “Oil has become critically important for financial markets, impacting corporate profits, capital spending, emerging market economies, and credit markets.”
As for the banks, they may be hit by a flattening of the yield curve and underperformance. This is because gradually rising rates could cause short-term rates to rise more than longer-term rates.
“This happened last week after the Fed announcement, which led to underperformance by the banks on prospects for narrower net interest margins, the difference between banks’ cost of funds and the rates on loans,” he explained.
Overall, LPL sees the rate hikes as supporting stock valuations. Of course, it could lead to volatility, but that does not change the team’s forecast “for steady, but not spectacular, economic growth in 2016 and modest gains for stocks,” White says.