The US Federal Reserve decided last month to leave interest rates on hold while signalling it expects to raise rates sooner rather than later – 13 of the Fed's 17-member committee expect rates to be higher by year end. The six-year bull market has been looking shaky in recent months: will higher rates kill it off?
There is certainly no shortage of commentators warning financial markets may be rattled by any rate hike, with the International Monetary Fund, World Bank and a host of prominent commentators such as former US treasury secretary Larry Summers advising the Fed to take things as slowly as possible.
Futures data shows markets now expect any rate increase to be delayed until March 2016, despite the Fed’s insistence that a 2015 hike remains likely.
Rising rates
As for investors, the conventional wisdom is that stocks are hurt by rising interest rates, although the truth is more complicated than that. In June, influential money manager
Jeremy Grantham
dismissed the “hysteria” over the prospect of a rate increase, noting stocks went up “all the time without missing a beat” between 2004 and 2006, despite having been hit with eight rate hikes.
Grantham, who sees stocks as very overvalued, has long argued indices will not peak until ordinary investors pile in, possibly driving the market to bubble valuations in 2016.
Others, such as former Fed chairman Ben Bernanke, argue stocks are not overvalued. Yes, stocks have tripled since 2009, but valuations were "severely depressed" then. "Arguably, the Fed's actions have not led to permanent increases in stock prices but instead have returned them to trend," he says.
Valuations aside, market history does not suggest rising rates need prove disastrous for stocks.
Since 1985, says BMO Capital Markets, the worst returns occurred when rates were low and declining; better returns were associated with environments where rates were rising from low levels. Similar findings are reported by US investment firm JV Bruni, with stocks outperforming during Fed tightening cycles over the 1956-2013 period.
High-profile finance professor Jeremy Siegel is also sanguine, arguing the current "uncertainty surrounding the guessing game about any action has actually been hurting stocks more than an actual move".
Siegel says the first rate hike is not associated with ending bull markets; rather, it is near the end of the rate-tightening cycle, which can last years, before returns tail off.
Deutsche Bank, which analysed the effect of past rate hikes on stocks in its latest long-term asset return study, suggests the negative impact of rate hikes “may not be felt until late 2016 at the earliest or even well into 2017”.
However, Deutsche Bank also notes the current circumstances are unique. Rates have been raised 118 times since 1950, it says. In all but two cases, GDP growth had been running above 4.5 per cent.
“All hiking cycles to date have been in a supercycle of increasing leverage with GDP eclipsing prerecession peaks very quickly post the recovery commencing,” analysts noted. “By contrast this has been a uniquely slow recovery from what was the worst recession in the sample period.”
It has been 75 months since the last recession ended, and still rates haven’t been hiked – that’s more than twice as long as the previous longest post- recession wait. The last time rates increased was in 2006 and again, that’s almost twice as long as the previous longest cycle, between 1989 and 1994.
Investors could be forgiven for forgetting just how common tightening cycles are; historically, rates are hiked about 18 months after the previous tightening cycle ended. Over the last half century, stocks have been in a tightening environment about 40 per cent of the time.
The severity of the 2008- 2009 recession and the slowness of the recovery has necessitated truly unprecedented monetary policy. We can look to history for clues as to what happens next, but this time may well be different, to use that oft-mocked phrase.
Indeed, some suggest that if history offers any message, it is a cautionary one. Ray Dalio of Bridgewater, the world's biggest hedge fund, has long drawn parallels between recent times and the pre-1937 era. Dalio, whose grasp of market and monetary history helped him foresee both the crash of 2008 and the Fed-supported recovery the following year, notes both eras saw market crashes (1929 and 2008). In both periods, subsequent years were characterised by very low interest rates, money printing and a cyclical recovery. Stocks halved, however, after the premature tightening of 1937. Unsurprisingly, Dalio is urging the Fed to hold off on rate hikes.
Low-rate world
There are also, of course, huge differences between now and 1937. Unemployment was very high then, compared with just 5.1 per cent in the US today, while stocks were hit by major fiscal cutbacks as well as monetary tightening.
Furthermore, a hesitant tightening of monetary policy is very different to a tight monetary policy. During past hiking cycles, rates rose quickly. In 1994, the federal funds rate went from 3 per cent to 6 per cent within a year. Between June 1999 and May 2000, rates rose from 4.75 per cent to 6.5 per cent. Between mid-2004 and mid-2006, rates went from 1 per cent to 5.25 per cent.
That’s not going to happen this time. Rates will remain low for years; the Fed, which does not expect inflation to hit 2 per cent before 2018, estimates rates will be 1.3 per cent at the end of 2016, 2.6 per cent at the end of 2017 and 3.3 per cent at the end of 2018.
Markets, which have correctly predicted for some time that the Fed would be forced to row back on its rate-hiking plans, expect even lower rates, with futures data indicating rates to be just 1.5 per cent in three years’ time.
What happens if the US, in expansion mode since 2009, is eventually hit by recession? The typical response is to cut rates; that would mean a return to Zirp – zero interest rate policy. For all the agonising about when interest rates are about to rise, it’s clear investors will continue living in a low-interest rate world for some time to come.
It’s also clear the Tina argument – “there is no alternative” to stocks in a low-rate environment – is as superficial as the argument that rate hikes must be bad for equities. Not once did rates dip below 3 per cent between 1934 and 1953; although equities ultimately did very well, there were no fewer than five bear markets during that period.
More recently, rates were slashed between 2000 and 2003 and again between 2007 and 2009, both of which were distinctly inauspicious periods for stocks. Nor have rock- bottom rates prevented Japanese stocks from going nowhere over the last two decades.
Uncertainty
So, to recap: history indicates stocks can do just fine during rate-hiking environments, underperforming only at the latter rather than the initial stage of the cycle.
However, this time really may be different, given that monetary policy in recent years has been unprecedented.
Secondly, for all the hullabaloo regarding looming rate hikes, it’s clear rates will remain extremely low for years to come. However, the “low rates good” assumption is no more valid than the “high rates bad” notion.
So where does that leave investors? The best approach may be to accept that interest rates are just one variable in an uncertain world – a message than can easily be forgotten amidst the incessant focus on the Fed’s next move.
