Have you ever been out to a great dinner, or on a great vacation, or perhaps at a great show, really enjoying yourself, yet knowing in the back of your mind that the bill for this great experience would come due, and it might be a doozy? Think about that experience and feeling, apply it to today’s markets, and ask yourself: how will investors feel when it’s time to pay the bill?
We’re not writing this to imply that a market crash akin to the Financial Crisis is just around the corner; far from it. We see ourselves in a slow-growth world that is a result of the experimental monetary policy by governments and central banks (CBs). They are manipulating interest rates without providing comparable fiscal stimulus to recover from a financial downturn, and as a result, these easy rate policies around the globe have lulled investors into a false sense of complacency.
Just looking at this small sampling of market returns gives us some idea about the effects of the CB’s policy of low rates:
During the period when the U.S. Fed embarked upon its Quantitative Easing programs (QE) and Operation Twist, the stock and bond markets earned much of the total returns since the low of the Financial Crisis. Other central banks, particularly in Europe, chose different paths that focused initially on austerity and had less robust results (e.g. a ‘double-dip’ recession in the U.K.). Across the globe, however, it appears that the ability for continued monetary policy stimulus to drive growth is limited. We are left with stagnant growth levels, negative interest rates in many countries, market uncertainty and growing populist movements that promote nationalism over growth.
Central banks are not united in policy goals, governments and corporations are not engaging in enough (if any) fiscal stimulus, and the world’s growth engine for many years—China—is retrenching and transforming. All of this leads to a suspicion that stocks and bonds are overpriced, particularly on the part of income-seekers driving money into utilities and other high-dividend stocks. This is clearly an important inflection point. We must accept that issues that have become political ‘hot button’ talking points—global trade, immigration policy, tax reform and populism—are perhaps now more important drivers of future growth than furthering the low interest rate policies that have dominated the past seven years.
Investors have asked us, are we worried about a bear market? A combination of several indicators turning bearish would cause us concern, such as much higher interest rates and inflation, an inverted yield curve and stock overvaluation. Recent market gyrations seem to be overreactions at this point; U.S. economic data do not currently predict a recession or an inflationary environment that would require the Fed to quickly raise rates. This does NOT mean valuations are at relative discounts—low rates are pushing some investors to equities, and areas such as utilities will be the first to sell off as rates move.
We’re seeing a lot of investment suggestions for private equity, private or second-market debt funds, real assets and options-hedged equity products. All are expected to provide better risk-adjusted returns than conventional stocks and bond portfolios. Our evidence doesn’t support many of these ideas. As we learned eight years ago, and can see in the table above, the traditional relationships between stocks and bonds provides the insurance and low correlation we need. In times of crisis, U.S. Treasurys and public-market liquidity (such as U.S. large-cap equities) are the prized investments.
Our clients know, too, that we preach diversification, patience and a focus on the far horizon, not the next step. The market data we review indicate that the U.S. economy is still healthy (but not robust), and few signs of the high rates, high inflation, excessive stock valuations or a recession are present. We expect some volatility in the period ahead, but our long-term growth outlook remains positive.
Investors and consumers alike are understandably interested in the ups and downs of interest rate cycles. The Federal Reserve, in addition to managing U.S. monetary policies, apparently has a new hobby: art.
Investors are focusing on the Fed’s “dot plots,” which are forecasts for the central bank’s key interest rates. The dots seem to be going up, indicating that Fed officials predict the interest rate will be rising in the coming years. Here’s how it currently looks:
Researching Beyond the Dots
At JJ Burns & Company, we take the fact that the Fed’s rather simplistic dot plot has become a focus point for investors with a bit of a grain of salt. An oft-repeated axiom is that the markets like certainty, despite the fact that we live in an uncertain world. So we’d like to suggest the Fed provides us with a more detailed dot plot that may look something like this:
Georges Seurat, and his fellow Pointillist artists, composed their works with thousands of dots or very fine brushstrokes. The artists would carefully blend many dots to create images that become clearer as the viewer steped back to look at the complete work.
Investors may want to take a page from the Pointillist approach into their individual investing strategy—considering the range of economic data, such as inflation (or deflation), GDP and employment statistics—and looking at the bigger picture in making their financial decisions.
So while the possibility of rising interest rates can be unsettling at times, they can also bring on positive projections. These include:
Higher nominal rates on fixed-income instruments, particular shorter-term paper
Generally stronger economic activity
Better earning environments for financial institutions as loan volume and rates increase
Potentially stronger equity market returns
Acting on Varying Interest Rates
Overall, the Fed is still being cautious about hiking interest rates. The Fed appears to be committed to a slow and measured increase in the cycles, with the intent to raise interest rates to a level where they will be able to lower rates again to stimulate the economy. They must also take into consideration the impact of pushing the dollar’s strength higher in an environment where many other central banks are pursuing expansionary policies, as that may negatively impact revenues and earnings for U.S. stocks.
Almost certainly, stock and bond volatility will be higher given the many swirling headwinds and tailwinds in the current global economy. We believe that past correlations between stocks and bonds (specifically with relation to credit spreads) will hold despite the low rate environment, and that the Fed rate increases will be quickly absorbed by the markets.
Making Investment Decisions
All of these events mean that investors may find themselves in difficult places. The Fed’s various stimulus programs (QE and Operation Twist) have helped reflate asset prices pummeled during the financial crisis. However, a lighter touch may have led to fewer rounds of QE or a modest rate hike earlier in this recovery, when more data pointed to less precarious circumstances.
Planning for the Future
Whether you make decisions based on dot plans or choose to step back, it’s important to gather key information and look at the bigger picture. JJ Burns & Company can help you connect the dots with a financial plan that addresses your—and your family’s—needs. Learn more about how we can work with you to plan for your financial future.
Should you be worried about an interest rate hike?
The Federal Reserve is expected to begin raising interest rates at some point this year. How will this impact the market and your retirement portfolio?
Join JJ Burns & Company on Thursday, May 28th at 1:00 pm EST for a free webinar to discuss the 2015 Economic & Market Outlook. During this live presentation, CEO JJ Burns and Managing Director Anthony LaGiglia will review our outlook and strategy for today’s markets.
In this 30-minute webinar we'll talk about:
How various asset classes have performed year-to-date
Whether interest rate hikes are bad for the stock market
How rising rates may affect your bonds
Plus we’ll also answer questions from attendees.
Don't miss this informative event! Reserve your spot today.
[Update: For those who couldn't attend, you can watch the webinar video here.]