John Lynch, Mid-Atlantic
David Roda, CFA, Southeast
Cam Hinds, CFA, Great Lakes
Marc Doss, CFA, CFP, California, Nevada
Michael Serio, CFA, CAIA, Mt. Northwest
Sean McCarthy, CFA, Southwest
Kei Sasaki, CFA, Northeast

In this Monthly Market Advisor:

  • The December 14 interest-rate increase by the Federal Reserve is only the second since it cut borrowing costs to near zero in 2008. Monetary policymakers find themselves in a conundrum: Will the normalization of interest rates negatively impact financial markets and investment portfolios?
  • We believe that the normalization of interest rates will be an extremely slow and gradual process that will likely take years and not months.
  • The recent trend for the relative outperformance of passive strategies over active management should lessen, if not reverse, as market interest rates climb higher.
  • However, we continue to recommend both active and passive strategies within portfolios because both strategies offer the potential for consistent long-term outperformance. We recommend positioning investment portfolios in a diversified strategy employing our four asset class approach.

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The Federal Reserve (Fed) has implemented innovative strategies attempting to spur consumption, lending, and investment since the financial crisis in 2008-2009. The anticipated spike in economic activity and inflation, however, has been slow to develop. Rather, the primary beneficiaries of this monetary largess have been the owners of riskier assets, such as stocks. Consequently, monetary policymakers find themselves in a conundrum; economic data support the removal of extraordinary measures, yet the combination of low/negative interest rates globally and the seeming dependency of the performance of riskier assets on historically low interest rates suggests that market volatility may escalate even with the slightest constriction of monetary conditions. Investors should take note as diversified and active strategies are likely to benefit as the Fed gradually shifts to a normalized policy.

The Fed: Historical perspective and response to the 2008-2009 financial crisis

The Fed was established in 1914 in an attempt to prevent another financial crisis similar to that experienced in 1907-1908. After several iterations throughout the ensuing century, the modern day Fed has gained independence from the U.S. Treasury and operates under a "dual mandate" of ensuring maximum employment and stable prices. In order to accomplish these objectives, monetary policymakers traditionally established a target for the overnight lending federal funds rate and through open market operations, the purchase and sale of U.S. government securities aimed at keeping interest rates around target levels.

Given the deflationary and global scope of the financial crisis of 2008-2009, however, monetary policymakers had to adjust policy even further, enacting emergency measures, including taking the overnight lending rate to zero and employing three separate quantitative easing (QE) programs. QE is an unconventional policy tool whereby the central bank purchased extensive amounts of government securities in order to lower interest rates and increase the amount of money circulating in the economy. By transferring electronic reserves to primary dealer depository institutions, the Fed essentially "printed money" and placed the purchased assets on its balance sheet, which expanded from approximately $800 billion in the summer of 2008 to $4.5 trillion today. Even though the final QE3 program ended more than two years ago, the Fed has committed to maintaining an elevated balance sheet by taking the proceeds from maturing securities and purchasing newly issued government bonds.

The results of these extraordinary policy measures have been mixed. After eight years, economic growth and inflation remain below historic trends in the U.S. Elsewhere, the combination of China’s transition to a consumption/services economy and the fallout from the financial crisis continues to weigh on economic and financial market activity in developed and emerging nations. Another challenge throughout much of the developed world is that fiscal legislators have not enacted growth-oriented policies commensurate with accommodative monetary stimulus. As a result, confidence in elected officials has waned and boosted support for non-traditional candidates in the U.S. and Europe.

One area where the effects of monetary policy have been indisputable is in the performance of risk assets, like stocks. The S&P 500 Index has climbed in excess of +225 percent since the lows of the 2008 financial crisis,1 while sovereign and corporate bonds have enjoyed solid returns. In contrast, the lack of investor conviction in hard assets, such as commodities, has been evident with a discrepancy in performance between precious and industrial metals.

The surge in global liquidity has also boosted passive investment strategies, where the rising tide has lifted the majority of boats. This increase in correlation of as well as within asset classes has weighed on the performance of active managers in recent years. This phenomenon is most evident in actively managed hedge funds. This group traditionally places bets on low-correlated assets, and has struggled in the environment of expanded central bank balance sheets, low interest rates, low inflation, low volatility, and high correlation of returns.

Will the normalization of interest rates negatively impact investment portfolios?

Considering the reaction of the financial markets to the December 2015 and December 2016 federal funds rate increases, a little perspective is in order. Interest rates remain remarkably low by historical standards. The most recent increase in the federal funds rate, to approximately 0.65 percent, pales in comparison to its average of around 5.0 percent over the past 50 years. Over the same timeframe, GDP has averaged almost 3.0 percent, inflation more than 4.0 percent, and the unemployment rate in excess of 6.0 percent. The benchmark 10-year Treasury, recently trading around 2.50 percent, is still well below its 50-year average of more than 6.50 percent.2

With the U.S. economy and inflation both tracking an annual rate around +2.0 percent, and an unemployment rate near 5.0 percent, it seems clear that monetary officials no longer need to employ emergency measures. Even with the new administration and President-elect Trump’s plans for fiscal spending, rates are well below historical standards. Considering the global challenges that Fed Chair Janet Yellen currently faces, we believe that the normalization of interest rates will be an extremely slow and gradual process that will likely take years, and not months, before even approaching historical averages.

We believe Yellen has several reasons to take the "go slow" approach:

  • Inflation is not yet a threat. Rising inflation starts with wages, which historically begets the classic wage-price-spiral that can become a self-reinforcing problem. Currently, average annual wage growth hovers in the +2.7 percent year-over-year (YOY) range, well below the approximately +4.5 percent YOY growth rate that has traditionally spurred central bankers into more aggressive action. The massive liquidity created these past several years must transition to income before it can manifest as an inflation problem.
  • Economic growth remains below historical trend as production, employment, income, and sales have failed in this cycle to return to growth levels achieved in previous economic cycles.
  • Negative interest rate policies prevalent in Europe and Japan may mean that global investors are likely to find value in the benchmark 10-year Treasury note when comparing valuation to other sovereign benchmark bonds, including the Japanese government bond and the German bund. Stated another way, global market participants may dampen the Fed’s attempts to raise rates too quickly.
  • While the Fed’s "dual mandate" involves employment and inflation, an unwritten but necessary consideration for the Fed has to include the U.S. dollar and emerging markets. Emerging nations now represent more than one-half of global output, and these nations have taken on more than $3 trillion in dollar-denominated debt to fuel their growth.3 If the Fed raises rates too aggressively, the result will likely be intensified capital flight out of emerging markets, weakening their growth rates and their currencies and pressuring their ability to service interest payments on this growing debt burden.

Diversified portfolios may provide the best defense against the gradual normalization of interest rates

As mentioned earlier, we believe that the recent trend for the relative outperformance of passive strategies over active management will lessen, if not reverse, as market interest rates climb higher. In addition, analysis of company fundamentals in active strategies can screen out those businesses that may not be able to outperform their peers due to a variety of reasons, including debt service levels, unique product challenges, and employee costs. As a result, the ability of active managers to pick and choose between who they believe may be winners and losers in a gradually rising interest rate environment, where volatility increases and correlations decrease, suggests favorable tailwinds for active management.

We continue to recommend both active and passive strategies within portfolios, though, because both offer the potential for consistent long-term outperformance. In an environment when interest rates move higher, investors must factor in the associated portfolio impacts, including growth in inflation and market volatility. We continue to position investment portfolios in a diversified strategy employing our four asset class approach of equities, fixed income, real assets, and alternative investments. Each of these areas is expected to experience opportunity and volatility as the levers for growth in the economy and the financial markets transition from monetary to fiscal stimulus.

Equities

The impact of higher interest rates on equities should largely be considered a positive development. The idea that the Fed believes economic and financial market conditions are sufficient to withstand a gradual increase in rates bodes well for this asset class as a whole. The challenge, however, is the degree to which market sentiment has been artificially supported by the extraordinary stimulus provided by the Fed. As a result, we suspect bouts of volatility will accompany the periods surrounding each hike in the federal funds rate, though we only expect two more hikes in 2017.

Correlations should continue to decrease as the Fed embarks on its gradual normalization of rates. For example, different sectors will likely experience varying results from higher interest rates. Cyclical sectors like Consumer Discretionary should perform well as incomes, consumption, and inflation move higher. Financials are also expected to perform well as net interest margins for banks begin to climb higher. Industries that have served as bond proxies, however, like Telecom Services and Utilities, may struggle as investors pursue other opportunities as rates shift from historically low levels.

From a valuation perspective, many investors may grow concerned that market price-to-earnings (P/Es) valuations may contract with higher rates. Equity multiples should not be viewed myopically but instead relative to interest rates and inflation. Though the current P/E on the S&P 500 Index is above its historical average, the yield on the 10-year Treasury is over 400 basis points below its long-term average, and inflation measures are approximately 30-40 percent of its traditional reading. Therefore, Wells Fargo Investment Institute believes that multiples still have room to move. Additionally, history has also shown that the P/E ratio for the market typically doesn’t decline until inflation measures exceed +4.0 percent average annual growth rates.

Long-term P/E ratios for the S&P 500 Index under different inflation environments



Chart of price-to-earnings ratios for the S&P 500 index during inflation periods from the 1950s through present. Contact your Relationship Manager for more information.

Source: FactSet, 11/28/16

Bonds

Clearly the impact of higher inflation and interest rates can weigh on the psyche of investors and the performance of individual bonds. Investors may grow concerned about two things:

  1. Inflation eating away at the value of their future fixed coupon payments
  2. Principal erosion as bond prices fall as investors demand higher market rates to compensate for the risk of owning bonds in rising rate environments

Yet similar to equities, a diversified portfolio approach can help mitigate the volatility within fixed income portfolios. For example, even though the yield on the benchmark 10-year U.S. Treasury has climbed more than 100 basis points over the past several months, it still sports an attractive valuation when considered against other benchmark sovereign bonds, including Japanese government bonds and the German bund. But a diversified fixed income portfolio can still benefit from the income-generation phase of the credit cycle, where bids for the benchmark can lead to a period of coupon clipping. Moreover, despite the rise in the 10-year Treasury yields, no stress has been evident in investment-grade corporate bond spreads, which have narrowed despite market volatility. High-yield bond spreads have also come in, though we caution against chasing yield farther out along the risk curve.

Real Assets

This is another group that may see mixed results, suggesting the need for diversification. Periods of rising interest rates tend to weigh on performance for real estate investment trusts (REITs), whose relatively high yields attract investor interest during periods of low interest rates; when rates increase, demand frequently lessens for this asset class. Commodities may experience more mixed performance as the Fed gradually raises interest rates. On one hand, the very need for tighter policy is likely to lead to anticipated growth and inflation, suggesting that industrial metals like copper are increasing in value. Yet a less accommodative Fed, the stronger dollar, and limited demand should impact prices for many precious metals, which are priced in dollars, including gold. Consequently, diversification within asset classes can play a particularly important role in your investment allocation to real assets.

Alternative Investments

Alternative investments may be the biggest beneficiaries of tighter monetary policy. This space has struggled as the balance sheets of global central banks expanded, resulting in a bid for all risk assets and pushing correlations higher. In an era of gradually tighter policy, even the slightest move in interest rates from historic lows can play a role in reducing correlations among, and within, asset classes. This should provide a variety of strategies within the alternative investments classification to profit from the identification of mispriced assets.

For example, Equity Hedge historically has tended to thrive in an environment that represents a market of stocks rather than a stock market. The latter suggests a rising tide lifting all boats (passive investment strategies) while the former favors active management, where fundamentals matter. The increase in dispersion, or differing returns among equity sectors, for example, indicates an improved environment for gains on both the long and short sides. Likewise, Relative Value can provide investors with improved risk-reward tradeoffs within structured credit than typical fixed income investing. Periods of low/reduced correlations can support Macro strategies too, which tend to benefit when volatility increase, providing diversified portfolios with downside protection.

Conclusion

The last eight years have been among the most eventful in the history of global central banking with many central banks enacting a variety of innovative policy solutions. Dramatic reductions in overnight lending rates, quantitative easing, collaborative approaches to maintain global liquidity, negative interest rates, and the maintenance of elevated balance sheets have all combined to suppress market interest rates. While the Fed’s initial goals of increased consumption, lending, inflation, and investment have not all been met, the Fed is nonetheless in the position to remove emergency measures supporting the U.S. economy.

Ordinarily this would be considered an achievement, but in an era where risk assets have become dependent on policy, the repercussions of slightly higher rates may be felt more acutely at times as policy accommodation is removed. Yet perspective is important when considering the relative moves in interest rates and their impact on investment portfolios. For these reasons, we emphasize the need to remain diversified, where portfolios exposed to a variety of asset classes can benefit from the reduction in correlations and the likely transition to fundamental and active strategies.


1 Source: FactSet, 11/28/16
2
Source: FactSet, 11/28/16
3
Source: Bank for International Settlements, 86th Annual Report, 6/26/16 http://www.bis.org/publ/arpdf/ar2016e_ec.pdf