Long-time readers may remember that in an embarrassingly premature fashion, I began writing about the upward path away from non-crisis interest rates toward normal several years ago. It looks like liftoff day has finally come, however.
The consensus expectation, informed by judicious leaks by the Fed, is now that the Fed Funds rate will rise by .25% next month, and by another .25% before yearend–meaning short rates will exit 2015 at .50%. A highly stylized view of the Fed’s intentions is that it will continue to raise rates at the same 1/4% clip at every second Fed meeting next year–meaning another 1.0% increase during 2016. The goal of rate normalization is an endpoint for Fed Funds of around 3% (but probably lower).
This is a potentially important change of direction for two reasons: rates have been at emergency lows for an extraordinarily long time, and the thirty-five year war against inflation has been long since won. The secular trend of ever lower nominal interest rates–for many financial market participants, the only trend they have ever seen in their working lives–is over. Barring another world financial disaster, nominal rates may be higher in the future, but there’s no chance they’ll ever be lower. So the thought habits of a lifetime are about to be shaken up.
What does this mean for stocks?
Past tightening cycles have been bad for bonds, but stocks have been flat to up. The generally accepted explanation for the latter phenomenon is that the negative effect of higher rates is offset by robust profit growth. Said another way, positive earnings surprises (more than) offset the negative effect of price earnings multiple contraction.
Personally, I think this explanation is the right one.
Critics of the applicability of the idea to the present situation point out that this time rates will be rising long after the business cycle has turned. Therefore, they argue, the chances of a surprisingly large corporate profit surge are slim. In consequence, the “normal” protection for stocks against Fed tightening is absent.
Four thoughts:
–the reason rates are still at 0% is that the “normal” cyclical profit surge hasn’t happened yet. Maybe surge isn’t the right word for today’s situation, but world economies certainly aren’t firing on all cylinders yet.
–profit rises and Fed tightening aren’t independent events. The Fed has made it clear that it intends to tighten only to the extent that economic strength allows. The agency has often referred to the repeated disastrous mistakes Japan has made over the past quarter-century by tightening too soon. If profit growth doesn’t permit, tightening will go more slowly than many expect.
–for the S&P 500, half the index’s profits come from abroad. The EU (25% of profits) will likely be stronger next year than this; China may be, too.
–where else will money go? Certainly not into bonds. Cash is the only safe haven. It’s possible there will be a large outflow of money from stocks into cash. I don’t think so. That’s partly (mostly?) because I like stocks. More substantively, institutional investors may shade their portfolios a bit toward cash, but their large size means they can’t maneuver quickly, so the risk to them of betting against stocks in a major way and being wrong is enormous. In addition, my sense is that a defining feature of the bull market that began in 2009 is the lack of retail participation. If so, retail has already bet heavily–and incorrectly–against stocks.
A final point:
–yielding 0%, cash isn’t an attractive alternative to me at. However, given that the period of zero interest rates is coming to an end, I’ve got to ask myself at what level would it be?
If we assume that inflation will be steady at 2%, I would find 3% cash and a 4%+ long bond very attractive. That may be evidence that we’ll never get there.
Still, what I’m trying to get at is that there will come a point in the tightening cycle where even an equity fan like me will have to reallocate toward fixed income. We’re nowhere near that now, in my opinion. But I think this, not the start of tightening, will be the real showstopper for stocks. This is not an idea to act on, but it is one I think we should keep in the back of our minds.