As you know, I find Mitch Zacks’ columns to be full of educated common sense. I was told I could repost occasional columns as long as it wasn’t too often and as long as I gave him credit.
He’s a Senior Portfolio Manager at
Zacks Investment Management
Attn: Wealth Management Group
One South Wacker Drive, Suite 2700
Chicago, IL 60606
I shortened this somewhat.
As I indicated last week, one of my major concerns for the market regards rising interest rates. Quite simply interest rates have been too low for too long. What do I mean by this?
Well a good way of gauging interest rates over time is to examine the yield on ten-year treasuries.
Now the yield is of course the interest rate necessary to make the current price of treasuries equal the present value of future income streams an investor gets from holding the treasuries. Since 1962, the average ten-year yield has been 6.56%. Currently the yield is 2.70% down from 2.77% at the beginning of April. Just take a second and examine the data.
Ten Year Treasury Yield Since 1962 - Annual
1962 - 3.95 1981 - 13.92 2000 - 6.03
1963 - 4.00 1982 - 13.01 2001 - 5.02
1964 - 4.19 1983 - 11.1 2002 - 4.61
1965 - 4.28 1984 - 12.46 2003 - 4.01
1966 - 4.93 1985 - 10.62 2004 - 4.27
1967 - 5.07 1986 - 7.67 2005 - 4.29
1968 - 5.64 1987 - 8.39 2006 - 4.80
1969 - 6.67 1988 - 8.85 2007 - 4.63
1970 - 7.35 1989 - 8.49 2008 - 3.66
1971 - 6.16 1990 - 8.55 2009 - 3.26
1972 - 6.21 1991 - 7.86 2010 - 3.22
1973 - 6.85 1992 - 7.01 2011 - 2.78
1974 - 7.56 1993 - 5.87 2012 - 1.80
1975 - 7.99 1994 - 7.09 2013 - 2.35
1976 - 7.61 1995 - 6.57 2014 - 2.70
1977 - 7.42 1996 - 6.44
1978 - 8.41 1997 - 6.35
1979 - 9.43 1998 - 5.26
1980 - 11.43 1999 - 5.65
Average - 6.55%
What do we see? First beginning around 2008 and continuing through 2012 the yield on the ten year treasury fell from 4.63% in 2007 to a record low of 1.8%. This was a direct result of two things. First and most important was the huge recession in 2008. If you look back at the data, you see that when recessions hit, interest rates tend to go down as investors buy the safety of bonds to protect them from the recession. As investors buy bonds the prices of bonds increase and the yields on those bonds fall.
This helps explain why interest rates fell in ?08 and ?09 but why did rates then continue to decline through 2012? The answer has to do with the reaction to the recession by the Federal Reserve.
The Federal Reserve reacted to the recession by buying ten-year treasuries effectively pushing yields downward in an attempt to stimulate the economy. The move basically worked, and the U.S. economy as a result has fared much better than foreign economies.
What are we likely to see in the future?
On the side of keeping interest rates below historical levels, there is a massive amount of surplus capital sloshing around the global economy looking for yield, effectively keeping interest rates low. Also, wage inflation remains contained, both due to the supply of labor increasing dramatically with globalization, and increased productivity due to technological changes. Without wage inflation, we generally do not see price inflation, and price inflation is a major upward drive of nominal interest rates. The high interest rates of the 80?s were driven primarily by high inflation expectations.
Despite these fundamental factors keeping rates low, the table above shows two trends very clearly. First rates are lower than what they have been historically, and second they seem to have bottomed around 2012. We can argue about the pace of interest rate increases, but at the end of the day the Federal Reserve needs to eventually stop buying bonds as there is a limit to how big their balance sheet can inflate. As the Federal Reserve stops buying bonds and as the economy continues to recover, and investors are less fearful, interest rates are going to move upward toward historical levels.
Additionally, if you analyze interest rates over time, what you find is that changes in interest rates show a relatively strong degree of serial correlation. What this means is that if rates rose last year, it is likely to rise again next year, similarly if rates fell last year, they are likely to fall again this year. Now interest rates have already begun to rise, and most importantly current interest rates are very far below their historical average.
We are left with a very good prediction that interest rates are likely headed higher over the next few years as the Federal Reserve gradually ends its bond buying.
Well what will happen to stocks?
To answer this question it really helps to look what has happened in the past. Historically the technology sector has been the best performing sector in a rising interest rate environment and the utility sector has been the worst performing sector.
Essentially, the growth parts of the stock market tend to perform better in a rising interest rate environment while the more defensive names tend to come under pressure. Another way of thinking about this is that the more the stock is valued based on a known income stream as opposed to earnings growth into the future, the worse the stock performs in a rising interest rate environment.
Just as bonds dramatically underperform stocks in a rising interest rate environment the more bond-like a stock is the worse it performs in a rising interest rate environment. If interest rates continue their upward trend, I would expect utilities, REITs, and telecom companies to come under some pressure. I am much more comfortable owning consumer staples companies if you are searching for yield in a rising interest rate environment.
Additionally, stocks that tend to have relatively less debt on their balance sheet will generate better returns in a rising interest rate environment. The reason is of course that higher rates means higher interest payments on debt which puts downward pressure on earnings. This is the opposite trend we have seen since 2009 when stocks with high levels of debt have generally outperformed stocks with low levels of debt as rates have fallen and stayed low for a longer time than most investors were expecting, causing the earnings of companies with high debt levels to beat analyst earnings expectations. This is the main reason why low-quality stocks have been on a tear over the past few years.
Effectively, the market is at a tipping point, and the rotation towards technology and away from companies with high debt levels should continue to occur.
As rates continue to trend higher, we should see defensive, large-cap, debt intensive, companies come under pressure and companies that have less debt and greater earnings prospects continue to perform. There should be a rotation out of value and into growth. This rotation was interrupted a bit in April as interest rates trended lower, but the upward pressure on interest rates will resume, and my guess is that growth companies which tend to have low debt levels on their balance sheet will outperform value companies which tend to have high debt levels over the next few years.
Additionally, because the expansion is stronger in the U.S. than overseas, due to the intervention of the Federal Reserve large-cap, multi-nationals should continue to underperform smaller capitalization companies where the majority of the earnings come domestically.