Shaping a portfolio for 2015 (iv): interest rates

The Fed has made it clear that it intends to begin the multi-year process of raising short-term interest rates back to normal sometime in 2015.  The agency says it expects to boost the Fed Funds rate from the current zero to around 1.5% by next December.

This is a good news/bad news development for investors.  On the one hand, the economic data clearly show that the US is finally–after six years–coming out the other side of the Great Recession.  On the other hand, rising interest rates are typically not good for securities markets ( a rising return on holding cash makes long-term investments like stocks or bonds look less attractive.).

If the Fed were to begin next April, it would have to do a .25% interest rate increase about every six weeks to get to 1.5% by yearend.  That’s just the beginning, though.  Fed documents indicate that the final goal is a Fed Funds rate of 3.5%.

what history shows

Rising rates are unequivocally bad for bonds.

In contrast, inpast periods of Fed-induced rate rises stocks have gone sideways to up.  That’s because the downward pressure that rising rates exert has been offset by upward pressure from strong-growing earnings.

 four differences today

1.  In past plain-vanilla recessions, interest rate hikes come pretty quickly after the worst of recession is over.  So consumers are just starting to spend (a lot) to satisfy needs deferred during the downturn.  In this case, however, we’ll be six years past the bottom.  Is there any pent-up demand left?    …probably not.  So the typical surge in earnings may be absent.  This is a minus for stocks.

2.  The Fed has been unusually clear  for a long time in publicizing what it intends to do and over what time frame.  Arguably, investors have absorbed this information and already made some portfolio adjustments in advance of the Fed’s actions.  I don’t see this in fixed income markets, but…

3.  The rest of the developed world hasn’t made anything close to thepost-recession progress in that the US has.  As a result,foreign interest rates  either remain at emergency lows, or are even dropping.  Rising interest rate differentials–and a strengthening US$–suggest that international fixed income investors may increase purchases of Treasury bonds, cushioning the fall in their prices.

4.  The Fed is acutely conscious of the repeated mistake that Japan has made over the past quarter-century of trying to return to normal too quickly–and pushing that country beck into recession instead.  Because of this, it’s possible that stock market weakness might cause the Fed to slow down planned interest rate rises.

my take

I think rising interest rates will make 2015 a sub-par year for stocks.  Will “sideways to up” hold true as it has in the past?  I don’t know.  I think a lot will depend on whether the Fed’s commitment to raising rates is greater than its wish to have relatively stable financial markets.  My guess is that stability is more important.

The Fed’s ultimate target for short rates is 3.5%.  I think that’s too high for a 2% inflation world.  I think 3% is more likely.  But let’s keep 3.5%.  Add a 2% real return to that and we get the endpoint for the yield on the 10-year Treasury,  5.5%.  This would imply a price earnings multiple for stocks of 1/.055, or 18x.  Arguably, then, the current multiple on stocks already discounts all the tightening the Fed is setting out to accomplish.

Even I think that the last paragraph paints too optimistic a picture.  What I’ve written may ultimately prove to be correct, but I don’t think the consensus would be willing to put much faith in this idea.

My starting out point is that interest rate rises will make next year a volatile one for stocks.  Without positive influences from earnings growth or foreign money flows, rising rates have the power to push US stocks down by, say, 5% in 2015..  At the same time, I think that good stock and industry/sector selection will enable investors to generate positive portfolio returns.

Shaping a portfolio for 2015 (i): a look back at 2014

Yes, we’re barely into December.  But within ten trading days Wall Street will be closing up for the year.  There’s little professional investors can do at this point to influence how their year will pan out, other than to avoid possibly mucking things up through short-term trading.  The accountants will be eager to get a start on closing the books. So they’re happier if accounts don’t trade in the second half of the month.  In particular, they won’t want trades to happen that will hang over, unsettled, into 2015.  As a practical matter, the last two weeks of the year are the best chance professionals have to rest–and virtually everyone takes advantage of the opportunity.

In other words, we’re already close enough to the end of the Wall Street year to draw some conclusions about how the year has gone.

Well, then, how did my Strategy for 2014 hold up?

what went well…

–To start with the most basic, this time last year I thought stocks would produce gains again in 2014, although on a more modest scale than in 2013.  I expected a rise of 7% – 8% for the S&P 500 (not counting dividends), driven by earnings growth and with basically none of the price earnings multiple expansion that characterized 2013.

That has more or less turned out, although earnings have been better than I had anticipated.  Before the start of trading today, the S&P is up by 11.8% since January 1st.

–I thought outperformance would come from a mix of growth stocks, which usually do progressively better as the economic cycle matures, and high dividend payers.  My rationale for the latter was that a yield of 3%+ would be a good start on a total return that would come in at 10%-.  I mentioned MSFT as a particularly interesting company of this sort–but I also suggested looking in Utilities, Telecoms and master limited partnerships (assuming a tolerance for a messy tax return).  MSFT has done extremely well, thanks in large part to jettisoning Steve Ballmer.  Utilities have also been stars, at +21% as a sector ytd.  On the other hand, Telecoms have been caught in the winds of structural change and are little better than flat. The MPLs I’ve looked at have generated income but little in the way of capital gains.

–I also thought short-term volatility would be high for stocks.  It has been   …and I think this will continue to be true in 2015.

and not so well

–I thought that the EU would be showing increasing signs of life—not robust growth, but at least a healthier pulse–as the year progressed.  I also expected the Chinese economy to bottom out sometime in the first half and begin to strengthen in the second.  Both areas have been weaker than I thought.

I was more than bailed out in the case of the Shanghai (+31% ytd) and Shenzhen (+19%) exchanges, which were driven higher by the recent Beijing announcement of a trading link between Shanghai and Hong Kong.  But Hong Kong is flat ytd.  More important, around mid-year, evidence began to emerge that the EU was starting to slow down, not pick up.  Subsequent market and currency declines have made Europe a very tough place to make money this year.  The biggest issue was not how to deal with a rising euro, as I expected a year ago, but how to defend yourself against a falling one.  There was plenty of time to reverse course on the EU, but the fact remains that I didn’t see the slowdown coming.

other stuff

A year ago, I expected Staples to perform well, on the same rationale as MSFT   …but also because the sector has outsized exposure to the EU.  Despite my mistake on the EU the sector has outperformed.  But that’s because of a fall in agricultural raw materials prices.  So this one is a case of better to be lucky than good.

I haven’t been a big fan of Energy for some time.  That’s mostly because the big oils generally get little benefit from rising petroleum prices.  Also, I’ve been too lazy/uninterested to do the work needed to sort out winners from losers in the shale oil/gas business in the US.  Still, I was surprised that the oil price has fallen so far.  This is a net positive for stocks, in my view.  There’ll also be a time to take the contrary view on Energy and buy.  I don’t think we’re there yet, however.

a letter grade?

I’d give myself some sort of a B.  A big mistake on the question of US vs. rest of the world, but offset somewhat by the idea of rmeaining positive on on stocks.