There is a common saying that time heals almost everything. Yet, even as we embark on the fifth year since the pandemic began, most of
Fed Up? Don’t be. History is on Your Side
Published Date : July 28, 2015
Eight centuries ago, in a muddy field near the royal fortress of Windsor Castle, the unpopular King John was forced to strike one of history’s most important bargains. A group of rebellious barons, resentful of his heavy-handed rule and even heavier taxation policy, coerced his royal seal to one of the most important documents in human history. That document, the Magna Carta, or “Great Charter,” ultimately established a system of checks and balances as well as the individual liberties now widely enjoyed by modern democracies around the world.
Today, another “Great Charter” of our time, the compact between the Federal Reserve and its crisis-era monetary policies, finds itself at an historic crossroads. Similarly born in a period of great contention and brought into existence without historical precedence, this policy changed the modern landscape dramatically. The effect has been to stabilize the markets and provide the backdrop for global economies to heal over time.
With the economic recovery now entering its seventh year, the job market tightening, and inflation concerns percolating, this extraordinary policy is no longer considered an absolute virtue by the markets. In addition, rising concerns over whether excessive accommodation, if left unchecked, is fueling financial bubbles as well as the continued impact of low yields on pension and retirement incomes only add to the ongoing debate over how and when rates should rise.
Those economic realities have brought us to a major turning point for our interest rate policy. So what should you expect from this coming policy reversal in the year to come?
The easy throwaway being offered by most advisors is that you should expect more volatility in the markets and in your portfolio. While it is true that a rate hike may mark a turning point in policy and create volatility, it hasn’t historically been an inflection point for investment performance. Instead, the first rate hikes tend to come during the middle of the business cycle, a period when most investments continue to produce positive performance. So while near-term volatility may present itself, that volatility has generally proven to be a wonderful opportunity for long-term investors.
So far, stocks have shrugged off the prospect of any threat from an imminent change in interest rate policy. The general view on Wall Street is that any negative effects on stocks from marginally “tighter money,” at least in the beginning of the rate cycle, will be offset by the positive benefit of a stronger economy. This rate hike shares a common thread with history as it is occurring in the middle of the current business cycle, when profits are strong and the economy is growing. History tells us that despite the rate hike, stocks have averaged double-digit gains in the year before and after the first Fed move. Our own view is slightly tempered, but still a positive one, as we expect mid-to-high single digit returns for stocks over the coming year.
Over time however, rising rates will chip away at two of the pillars that have supported this rally: cheap corporate debt and low wages. With profit margins close to all-time highs, the odds of margins contracting as a tighter labor market collectively “asks for a raise” will rise. To avoid a profit crunch, revenues will have to rise fast enough to offset the inevitable pressure on margins. Only time will tell how this dynamic will play out but we suspect given widespread underemployment it will be manageable, particularly over the intermediate period.
Bond market performance, however, has historically been tougher during new rate cycles. In the months leading up to and immediately following a rate hike, bond markets tend to be flat to slightly negative performers. But over a longer-term perspective, bonds have recorded average low-single-digit gains in the first year after a rate hike. A long-term investment approach with bonds is important both for investment performance reasons and as a store of value should any stock market volatility presents itself.
Of course every rate cycle is different and this one is absolutely unique. For starters, this rate cycle begins from unprecedented low interest rate levels. Additionally, the return to normalization in monetary policy is likely to occur in small, incremental, and predictable changes for some years to come into the future. To this end, the Federal Reserve has specifically telegraphed a “one and done” rate move this year, which will work to help cushion the blow to returns in the immediate term. Longer term, as we look towards the end of this decade, rates will rise, perhaps by as much as 2-3% by 2020. But the rate of change will be extraordinarily slow, allowing your bond portfolio to reset naturally over time. As a result, those calling for a volatile environment appear alarmist to us.
Although predicting near-term market movements is a fools’ game, we do believe the absolute starting point for rates as well as the Federal Reserve’s “one and done” policy conveys a less aggressive stance than historical cycles. As a result, we suspect any so-called “Fed scare” will likely be mild and brief. And somewhat counter-intuitively, we believe that once a rate liftoff is considered certain and imminent, the S&P500 – assuming economic growth remains positive – may actually benefit, breaking out of its recent long standing trading range.
Longer-term, we continue to expect positive, but subdued return profiles for most financial asset classes, a reality of the current later stage economic environment. In general, it is reasonable to assume that returns will be modestly lower in the future than they have been in the past. After all, we have just experienced one of the biggest stock market rallies in history and this economic recovery’s best growth years are likely behind us.
That said, we are positioning stock portfolios for continued moderate economic growth, with a bias towards dividend stocks. Our general thesis is that we want to get “paid to wait” during this period of lower overall returns. Meanwhile, bond portfolios are positioned in a neutral manner as we see current interest rates now at equilibrium with underlying economic fundamentals. Finally, we see this environment as an opening for opportunistic investing, and continue to take advantage of investment opportunities as they present themselves around the world.
Even though it’s only been eight years and not eight centuries, the Federal Reserve’s “Great Charter” has certainly earned its place in history. Just as King John had to accept that he could no longer wield ultimate authority, so now the Federal Reserve is ready to do the same. Our view is the economic recovery is on solid footing, that a review of history tells us a more accurate story than the headlines of the day, and that the market is ready to stand on its own independent system of checks and balances.
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