two types of tightening
The Fed raises rates in two different situations:
1 to slow down an overheating economy. This is not where we are now. In the overheating situation, the economy is expanding at an above-trend rate. Inflation is accelerating. Wages are rising rapidly. The stock market is frothy. The long bond is trading at inflation +2% – +3% (meaning a nominal yield of 4% – 5%, in a 2% inflation scenario).
As the Fed ups short-term rates, what follows is a garden-variety recession/bear market. Bonds go down. Stocks go down. The damage to stocks is worse than the damage to bonds–often by a lot.
Again, this is not the situation we’re in now.
2) to restore money policy to normal after a period of extreme easing aimed at ending a recession or combating a severe economic shock. That’s where we are now.
In situations like this, bonds go down but stocks go sideways to up. There’s no theoretical reason I can see for the latter behavior. It happens, I think, because, unlike the overheating situation, the Fed doesn’t intend to bring growth down dramatically. It just wants to wean the economy off a sugar high of very easy credit.
Two things make todaydifferent from past rate normalization periods, however: the amount of easing has been very large and of unusually long duration; and dysfunction in the legislative and executive branches in Washington has meant fiscal policy has failed to do its part come to the country’s support, other than in the earliest days of the financial crisis.
Some argue that beause of this, today’s situation may be different enough that the past won’t be a sure guide. I’m going with history. But I take th point that we can’t just be on cruise control.
two different portfolio responses
The two types of tightening call for different stock portfolio construction, in my view.
In today’s world:
–bond-like stocks will probably not do well. Years of ultra-low interest rates have forced Baby Boomers to search for income in the stock market. As rates rise, and bonds become increasingly attractive, some Baby Boom money will return to bonds. At first, the reverse flow may only be new money. At some point, however, Boomers may begin to liquidate their income stocks.
–rising rates may make the dollar spike. In fact, the IMF recently expressed this fear in an emphatic plea to the Fed to postpone the start of the rate normalization process into 2016. It’s not clear to me that the dollar will appreciate much further, however. But if it does, stocks with foreign exposure will become less attractive, since the dollar value of their foreign earning power declines. On the other hand, foreign companies with large US exposure become more attractive, both to local investors and to you and me.
–companies with their own special growth story become more attractive than those that are mostly dependent on the general business cycle for their oomph. Cloud computing and Millennial favorites should be relatively fertile fields. Arguably, the market’s preference for growth stocks over value has been in place for some time. But the preference for the former should intensify.