Distracted by the drama in Greece and China, investors may have overlooked that the end of the easy US money era is coming to an end.
The messages from the Federal Reserve have little ambiguity, even when its words are chosen carefully. The cost of borrowing will shortly rise in the US. This begs the question of how investors will react when the Fed (and no doubt shortly after the Bank of England) raises the US cash rate.
The Taper Tantrum of May 2013, when then Fed chairman Ben Bernanke stated the blindingly obvious that emergency stimulus could not carry on forever, points to volatility ahead. But history suggests that rising rates are not necessarily bad news for investors.
Going back 40 years or so, both the period leading up to the first rate increase in a tightening cycle and the immediate aftermath have typically been associated with decent returns. Since 1976, eight rate-hikes have seen the S&P 500 rise by an average of 18% in the year before the turn compared with less than 12% for all one-year periods. Even in the year after the first rise, shares have outperformed the average, up nearly 15%.
Conventional wisdom
The conventional wisdom is that rising rates are bad for markets because they raise the cost of borrowing and subdue economic activity. They increase the rate at which future profits are discounted back to a present-day value which means that investors are prepared to pay a lower price to share in those profits.
But you have to ask why interest rates are rising. If central banks are responding to a pick-up in activity, rather than belatedly trying to suppress an inflationary spiral, then the improving backdrop can encourage share prices to rise.
You also have to look at the broader picture. The US may be the world’s leading economy but it still only accounts for around a quarter of global output. If the rest of the world remains stuck in an easing phase (as Europe, Japan and China are) then the net effect can still be accommodating.
So there may be less to fear about rising rates than we think. And some sectors, in particular, have a record of outperforming as yields push higher. Financials tend to do well, for instance. In part, this is simply a reflection of a strengthening economy, which reduces non-performing loans. It is also a product of fatter profit margins as banks increase the spread between the rate they pay depositors and the rate they charge borrowers.
Other sectors you might expect to do well after the Fed raises rates are consumer stocks. Companies that benefit from a healthier housing market as well as those selling discretionary items like cars, kitchens and meals out can outpace defensive staples like food, utilities and household products.
Finally industrial stocks selling to other companies – automotive parts, building products and the like – can be beneficiaries as activity expands.
Shy away from the ‘safe’
If this is how things will pan out, then investors might shy away from the safe, reliable stocks that have done so well during the recent grudging bull market. These high-yielding defensive companies have seen their shares rise as investors chased stocks that behave like bonds, havens with a decent income to boot.
I’m not convinced this is how things will work out this time. Rate rising cycles have rarely, if ever, started from a position of such high debts, which could keep a lid on the recovery for years to come. Rates normally start to rise when profits are low and just starting to bounce back, whereas the earnings recovery was achieved years ago in this cycle and profit margins are already high. Global demand outside the US remains tepid at best.
The net result of all this is likely to be a shallow trajectory for interest rates once lift-off is achieved. The next peak in interest rates will be a lot lower than the last one. Defensive, income-paying stocks have served investors well and I expect them to do so for a good while yet.
