The Long View – Where to Invest When Rates are Rising
The “lower for longer” era may be finally coming to an end.
Investors have been able to ignore the bond market and interest rates since the 2008 financial crisis simply because rates remained modest.
Low rates fuelled an extended economic recovery and a strong stock market.
As long as inflation did not spike, rates could stay low and the party could continue well into the night.
Fed gently pumping the brakes
The US central bank (Federal Reserve) says it wants to raise interest rates in an effort to cool down the rising inflation.
US inflation only just recently went past the Fed’s 2% target level.
But is the economy really overheating?
The Fed’s 2% target inflation level is not historically high.
Critics may point out that inflation has been stagnant and only now surpassed the target after a recent surge in oil prices.
The current, post-crisis economic recovery has been long but underwhelming.
The Fed wants to tame inflation, but it also need to be careful that rising rates don’t end up slowing investments and hurting the economy.
More ammo for the next recession?
Sceptics may say that the Fed is not raising rates to keep the economy from overheating but rather to provide ammunition to stimulate the economy when the next
recession comes.
If rates would remain low, future cuts during the next recession could have little stimulative impact.
In fact, recently Deutsche Bank hinted that a recession may be closer than we think.
DB said current developments in rates point to a coming “end of the Fed hiking cycle and the beginning of some easing”.
Why focus on the yield curve?
Suddenly market watchers are focused on the yield curve for the first time in years. Why? It could be signalling bad things to come for the economy.
The massive rise in the 2-year interest rate is startling compared to the slow rise in the longer (10 and 30 year) interest rates.
This means the curve is flattening (2-year at the same level as 10-year) and could start to invert (2-year goes above the 10-year).
Why should stock investors care?
There is an important relationship between the yield curve and the stock market.
The yield curve and the stock market are both considered leading indicators for the health of the economy.
But the yield curve’s anticipation of changes in the economy is earlier than that of the stock market, so it pays to watch the yield curve.
A flattening yield curve is often correlated with a recession.
The yield curve has flattened and inverted ahead of most of the past stock market peaks, with an average lead time of 6-9 months, but sometimes as long as 18-20 months.
Stock valuations look appealing again
Fortunately for investors, the global stock markets are more attractive now than they were at the start of 2018.
January valuations were sky high and blissfully ignorant of the impact that rate hikes would have on risk sentiment.
The tech sector is what brought the stock indices to crazy heights.
However, recent disputes over trade tariffs, intellectual property rights and data protection scandals brought the sector and global stock markets back to more reasonable valuations.
In fact, Bank of America points out that valuations have come down from the top quartile in January to levels that are now below the historical average in April.
This means there is now a much better risk-reward trade-off for stock investors.
Also, it is important to note that earnings growth in non-tech sectors remains robust and broad.
Earnings are strong because of resurgent demand, not just cost-cutting. In addition, banks are a good, defensive sector to play in anticipation of higher interest rates.
Commodities benefit from price recovery
The rebound in oil prices since extreme lows in 2016-2017 has been good for markets.
But be careful what you wish for: higher oil leads to higher inflation, which leads to higher interest rates, which ultimately leads to lower US stock markets and household wealth.
Oil and metals companies may continue to be attractive though, as prices of oil and many metals have rebounded but still remain much lower than the 2014 levels.
This means that there is plenty of upside for earnings, should commodity prices continue on a steady upward path.
Likewise, gold and silver are interesting in this market.
Why?
If inflation is on the rise at the same time that global growth is slowing, then we could enter a period of stagflation, and historically that has been a good situation for gold and silver.
Emerging Markets better positioned now
Five years ago, market experts would have warned to avoid EM in an era of rising rates.
EM stocks and bonds were hit particularly hard in 2013, the last time that rising US interest rates spooked the market.
The mid-2013 rates rise was known as the “Taper Tantrum” and many EM economies were economically vulnerable to rising rates.
This was particularly true for the so-called “Fragile Five” (Turkey, South Africa, Brazil, Indonesia and India).
However, since then, EM as a whole, and many of the formerly “fragile” countries, have improved their economies to an extent that leaves them much less vulnerable.
We have already witnessed that EM assets and currencies are holding up much better this year compared to 2013.
Thus, EM could remain an attractive area to invest, even in an era of rising rates.
Paul Connolly
Paul Connolly has been a journalist for more than 20 years, as a reporter and editor for Argus Media, Reuters, The Times, Associated Newspapers and The Guardian. He has covered Islamic Finance for Reuters in the 1990s. Paul has since helped launch three newspapers, as well as reported from Tokyo, Los Angeles and Stockholm.
