Thursday, July 18, 2019

Don’t Fight The Fed

Andy Means, CFA®
Author position
Director of Investments - Hilliard Lyons Trust Company

Investors may be feeling a bit of whiplash: The stock market plunged late in 2018, with the S&P 500® declining 13.5% in the fourth quarter − the third-worst Q4 performance in nearly 70 years. Then, in the first half of this year, the stock market roared back, with a surprisingly strong gain of 18.5% − the index’s best first-half performance in 22 years.

This abrupt about-face left many investors baffled. We think a change in the direction of monetary policy by the Federal Reserve (Fed) explains a lot of the stock market’s unusual activity over the past nine months.

An inverse relationship
Noteworthy investor Martin Zweig is credited with coining the advice “Don’t fight the Fed” several decades ago. Basically, he meant that the stock market and interest rates are inversely related: The market tends to rise when the Fed is cutting interest rates and to fall when rates are rising. This phrase has some true believers within the investment community who are always striving to predict the stock market’s direction. Recent market swings may reinforce this group’s beliefs.

Rates up, stocks down
The current cycle of Fed rate increases began back in December of 2015, with a .25% increase in the Fed funds rate following seven years of “ZIRP” (Zero Interest Rate Policy). In 2018, the Fed raised rates more aggressively with four .25% increases, the last coming in December. It also telegraphed plans for further rate increases in 2019. This turned out to be too aggressive for investors who feared the Fed was making a policy mistake just as the global economic growth rate was already slowing. With growing fears of a deep economic slowdown or recession, some investors sold their stocks aggressively.

Rates stable, stocks rally
Early in 2019, the Fed shifted its policy to neutral (or no further interest rate increases) for the time being. The declining stock market quickly reversed direction and rallied strongly in the first quarter. Fed policy shifted yet again in June, when it stated that interest rate cuts will likely be necessary to aid a slowing economy. This change further fueled the rally in stock prices and largely explains the market’s dramatic moves.

Why the inverse behavior?
Stocks react so positively to lower interest rates for many reasons:

  • Lower borrowing rates encourage economic activity by making it less expensive for individuals and businesses to make large purchases and fund new projects.
  • Lower rates also let borrowers refinance existing debt at lower rates, putting more money in the pockets of consumers and boosting earnings for businesses by lowering their interest expense.
  • Lower interest rates also make bonds a less attractive
    investment, and some of the money from bonds flows into the
    stock market.
  • Finally, lower interest rates have a powerful impact on
    business valuations. Businesses are valued much more
    highly in a low-interest-rate environment because the stream
    of earnings they generate are more valuable when prevailing
    interest rates are low.

All of these factors contribute to higher stock prices in a lowerinterest- rate environment. These are also reasons that the adage “Don’t fight the Fed” has become accepted Wall Street wisdom.

So why would the Fed ever increase rates?
If lower interest rates result in all of these positive developments, why not keep rates at rock bottom levels forever? The primary risk in doing so is overstimulating the economy, which can result in higher inflation, an increase in speculative and irresponsible economic and investment activity − or both. Too much inflation and excessive speculation always ends badly. Fortunately for the US economy and the Fed, the rate of inflation actually declined over the past year and continues to run well below the Fed’s target rate of 2%. This gives the Fed comfort with its stated plan to stimulate the economy through lower rates.

The anomaly of negative interest rates
Any discussion of interest rates today must acknowledge that worldwide interest rate levels are unprecedented, somewhat unbelievable, and likely unsustainable. A pool of about $13 trillion in bonds issued by a handful of countries carry negative interest rates! (This means that investors are actually paying for the “privilege” of lending money.) For most of economic history, this would have been considered impossible, because it makes so little sense from the lender’s standpoint. While the current yield on the 10-year US Treasury bond is amazingly low at 2%, it is one of the highest government rates in the world. Many countries in Europe and Japan have negative rates on their 10-year bonds. Underlying reasons for these unprecedented interest rates are systemically sluggish economic growth rates, fears of deflationary forces, and central banks continuing their Quantitative Easing policies to try to lift their countries out of economic quagmires.

I simply don’t know what to say about the worldwide interest rate structure today. Trillions of dollars of bonds with negative interest rates break many market rules governing how bonds should be priced. The new rules seem to be that there are no rules! Significantly higher interest rates in the United States are unlikely while negative interest rates exist around the globe.

The aging economic expansion
Speaking to a group of economists in early January at the annual meeting of the American Economic Association, the past two Fed chairs had an interesting exchange: Janet Yellen said “I don’t think [economic] expansions just die of old age,” to which Ben Bernanke added “I like to say they get murdered.” While these comments got a big laugh from the gathering of economists (no easy feat!), historical evidence confirms their assessment.

The current US expansion is now 10 years old and counting, although there are still pundits who worry that it will soon die of old age. When the Fed raised rates several times in 2018, many investors concluded it was going to murder the economic expansion with a policy mistake. The Fed now seems to agree with the negative signals sent by the investment markets late last year and is ready to pursue interest rate cuts. Perhaps the current members of the Fed were listening when the two former Fed leaders made their comments.

Tuning in to the signal, tuning out the noise
As we begin the second half of 2019, it is important not to get distracted by crosscurrents in the daily news. From politics to trade wars, from geopolitical tensions to predicting the Fed’s next move, there are plenty of headlines vying for attention. We think it is a mistake to let the news of the day drive investment decisions. In our rapidly changing world, it is vital that we remain disciplined and steadfast in our strategies to help you achieve your investment goals. With a high-quality emphasis in all that we do and a singular focus on the long term, we remain committed to your investment success.

Past performance is not a predictor of future success. All investing involves the risk of loss. Hilliard Lyons Trust Company does not provide tax or legal advice. Please consult your own tax and legal advisors about your own personal situation.