Interest Rates Archives — Page 18 of 24

What Do Higher Rates Mean for Asset Class Returns?

Higher interest rates coupled with signs of a global slowdown and roughly two months of market volatility — including several periods of a selloff — have clouded an otherwise positive picture of the U.S. economy. Despite this, many investors are still worried future increases in interest rates will hinder the economy, given growth in the U.S. and other regions is likely to slow down next year.

An analysis of the performance of different asset classes during U.S. rate hike cycles since the 1990’s suggests the opposite — these cycles were largely positive for investors. In fact, during the most recent hike cycle (Jan-16 to Nov-18), annualized returns for both private and public markets (excluding real estate) were well above their 1-year annualized rates of return before the initial hike began. The orange bars, which illustrate the various asset classes’ 1-year returns before the hike cycle, are well below their annualized returns during the cycle, as depicted by the colored columns. U.S. equities (S&P 500) outperformed other asset classes, gaining almost 12% during this period. U.S. buyout, non-U.S. equities and fixed income gained roughly 6%, 4%, and 1%, respectively. Real estate appears as the outlier with this most recent cycle, but comes on the heels of a considerable run for real estate after the Great Recession.

When looking at 1-year annualized returns after a hike cycle occurred for the prior three rising-rate regimes in 1994, 1999 and 2004, the data paints a similar picture. As illustrated in the graph, annualized returns 1-year after the hike cycle ended (when the effect of an increase/decrease in interest rates will be felt on a wide scale) were on average higher than returns during the cycle. This is depicted by the gray bars (1-year returns after the hike) being on average well above the returns during the hike cycles.

The volatility we have seen thus far in the market is typical for the later stages of an expansion and should not be solely attributed to the Federal Reserve’s tightening policy. It is important to note that interest rate hikes alone will not adversely affect asset class performance, but rather, the economic backdrop of each rate hike cycle will determine the market outcome. Given the uncertainty surrounding the current cycle’s path moving forward, investors should expect continued volatility and watch closely for upward-trending inflation.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Deciphering the Bond Markets: How Much Duration and Credit Risk Should I Take?

2018 Investment Symposium flash talk by Ben Mohr, CFA

Given the current fixed income environment of rising rates and tight credit spreads, investors are questioning how much interest rate risk and credit risk they should hold in their portfolios. This session addresses the questions of how much duration (interest rate risk) and credit risk investors should take by examining current market conditions, anticipated changes, and an overall assessment of where we are in the credit cycle.

A summary of this flash talk can be downloaded here.

Opening Keynote with John V. Miller, CFA

Marquette’s 2018 Investment Symposium opening keynote by John V. Miller, CFA, Head of Nuveen Municipals at Nuveen Asset Management

Does Shorter Duration Pay Off When Interest Rates Rise?

With the Fed poised to further raise rates this year as well as next, it is insightful to investigate how a bond’s duration can impact its return in a rising interest rate environment. Typically, a bond’s duration is used to gauge its price sensitivity to changes in interest rates. As most investors know, bond prices are inversely related to interest rates; the longer the duration, the greater the sensitivity to interest rate movements. In the event of rising rates, all else equal, a bond with a higher duration will decline more in price.

As a simple illustration of how duration can affect bond prices in times of rising interest rates, we compare the performance of short bonds — measured by the Barclays 1–3 Year Govt/Credit Index — and long bonds — measured by the Barclays Long Govt/Credit Index. At this point, the Federal Reserve is likely to announce two more interest rate hikes in 2018, with each hike expected to be 25 basis points. The respective durations for the two indices used in the analysis are approximately 1.9 and 14.9, respectively. Assuming a parallel shift in the yield curve and keeping other economic variables constant, the index values will decrease by 0.95% (short bonds) and 7.45% (long bonds), given the 0.5% increase in interest rates by the end of 2018. If this is true, does this mean that short duration bonds always outperform long duration bonds when interest rates goes up?

On average, the annualized cumulative return over seven interest rate rising periods since 1976 on the Barclays 1–3 Year Govt/Credit Index is 4.69% and 3.4% for the Barclays Long Govt/Credit Index. The correlation with interest rates is also consistently high for short duration bonds at 87% as opposed to 24% for long duration bonds.

At this point, the numbers suggest that short duration bonds tend to outperform when interest rates rise. However, the last two periods in the chart show the opposite trend — long bonds have actually outperformed their shorter duration counterparts. How so? A primary reason is how the shape of the yield curve changed during the last two interest rate increases, as not all rate increases are parallel shifts of the entire curve. The shifts in the yield curve for the periods 1994–1995 and 1999–2000 were indeed parallel whereas the last two periods featured rises on almost exclusively the short end of the yield curve. Rates were anchored on the long end during these periods due to demand from foreign investors looking for greater yield than offered by their home countries, particularly in Europe and Asia.

Overall, the chart shows that short duration bonds provide a more predictable return when rates rise, however a non-parallel shift in the yield curve can influence their relative performance vs. longer duration bonds. For institutional investors, if nothing else this serves as a reminder that trying to time interest rates and changes to the shape of the yield curve is an utterly difficult task to consistently get right, so investors are best served maintaining and re-balancing their bond allocations as dictated by their investment policy statements.

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Do Rising Rates Mean Lower Returns for EM Equities?

Rising rate environments are typically thought to put downward pressure on equity returns. Specifically for emerging market (“EM”) equities, the common perception is that higher interest rates in the United States will drive EM returns lower and investors away from EM securities. However, in looking at the annualized returns of the MSCI Emerging Markets Index over historical periods of rising rates, this may not be the case.

This week’s chart of the week shows the annualized return of the MSCI Emerging Markets Index in rising rate environments and the Fed Funds Rate at the start and end of those periods. Only one of the time periods — January 1994 to February 1995 — was negative, and the average return for the time periods examined is 14%. In the most recent period — from December 2015 through June 2018 — the MSCI Emerging Markets Index has returned over 11% annually. Contrary to common belief, in periods when rates are rising, EM equities seem to perform well.

What explains this performance? For one, economic fundamentals for EM economies have been strong. The annual real growth rate of GDP for developed markets has averaged 1.9% over the past 5 years, while the same measure for emerging markets has averaged 4.9%. The more recent poor EM performance is mostly due to an appreciating dollar, which makes exports from EM countries cheaper to purchase in the U.S. Longer term, however, the data suggests that EM returns could be positive as rates climb higher in the U.S.

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Being on Guard for Curve Inversion

Our chart for this week examines the shape of the U.S. Treasury yield curve. With the 10-year Treasury yield recently rising above 3%, the yield curve is now as flat as it was in 2007, just before it inverted as a precursor to the 2008 financial crisis. An inverted yield curve shows that the market does not expect future interest rates to be as high as today’s interest rates, and may signify an economic downturn — going hand-in-hand with an equity and credit correction — to come.

The horizontal axis shows the maturities of U.S. Treasury bonds while the vertical axis shows their yields. Each line is a cross-sectional snapshot — rather than a time-series — of the U.S. Treasury yield curve. The bottom-most line is the spot curve, which shows the current¹ U.S. Treasury yield curve. The next line up is a Treasury forward curve that shows where the market expects the yield curve to be at the end of 2018. The next line up after that shows the forward curve for one year later, at the end of 2019; and the highest line shows the forward curve for the end of 2020.

As we can see, the market expects the curve to pivot at the long end, and rise at the short end, suggesting further flattening.

While it is comforting to know that the Federal Reserve now has in its toolbox the ability to cut rates to support the economy, it is a concern how easily the curve could invert, say, if the Fed hikes only a few more times coupled with a drop in the long end of the curve. This drop could be due to a resurgence of geopolitical tensions or slower growth expectations.

The Fed continues to have the dual mandate of minimizing unemployment while containing inflation. As inflation and inflation expectations continue to rise, we may see the Fed continue its rate hikes in order to rein in the economy, making inversion that much more likely. Because of this, we encourage investors to be on guard for curve inversion, which means taking moderate risk in portfolios, remaining diversified and maintaining a suitable amount of duration. We will continue to monitor the likelihood of curve inversion in the quarters to come — in the context of key metrics such as valuations, fundamentals and technicals — to help ensure that our clients’ portfolios are well-positioned.

¹ Data as of May 18, 2018

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What Do Higher Interest Rates Mean for Higher Yielding Equity Sectors?

It looks like interest rates will dominate both fixed income and equity markets in 2018. Potentially higher interest rates have not only negatively affected bond markets, but have also wreaked havoc in certain sectors of the equity markets. Particularly hard hit:

Consumer Staples, down 7.1%;
Telecom, down 7.0%;
Real Estate, down 6.7%, and
Utilities, down 4.7 %.

Predictably, these are the worst performing sectors in the S&P 500 through April 13, 2018. The S&P 500 was down 0.1% over the same period.

Given the stubbornly low interest rate environment after the Global Financial Crisis, investment firms created a plethora of high dividend indices and strategies to respond to the world’s demand for yield. Investors who were not comfortable taking a bet on long duration bonds often invested in high dividend yield strategies to capture yield premiums over the 10-year bond and S&P 500. After a few years, high yielding sectors were often among the best performers in the market. For instance, in 2014 the Telecom sector returned 29.0%, trouncing the return of every other sector and the S&P 500 index.

Dividend-oriented ETFs saw $40B in net inflows which was in stark contrast to equities which have seen outflows over the same time period. However, there have been periods of outflows, namely during the Taper Tantrum in the summer of 2013 and in December 2015 after the Fed’s first interest rate hike.

However, the interest rate outlook is very different today versus three years ago. The global economy is strong and the U.S. is embarking on an interest rate normalization process. Since year-end, the yield on the 10-year bond increased 0.4% from 2.4% to 2.8% and the S&P 500 Dividend Aristocrats index, a proxy for high yielding stocks, yields 2.5%, which is lower than the yield on bonds. As fixed income’s yield prospects have improved, the interest in bond-proxy sectors has waned and investors are starting to withdraw assets. Although outflows are not as extreme as in December 2015, the return prospects of bond-proxy sectors could be challenged further as rates continue to rise.

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Can Low Interest Rates Justify High Stock Valuations?

Given the persistence of above-average equity market valuations in recent years, a proclamation oft-heard from the financial press and market pundits alike is that today’s low interest rates justify these higher valuations. Intuitively, it is easy to see how the rationale behind such statements originated. At the most basic level, the intrinsic value of stocks (and most assets) is the present value of their discounted future stream of cash flows, where the required rate of return (“discount rate”) reflects the riskiness of those cash flows. For instance, discount rates for stocks are higher than those for bonds due to the greater uncertainty of cash flows to equity owners. Because of this framework, and noting that lower discount rates will result in higher present-day asset valuations, it can be easy to empathize with the notion that lofty stock prices today, relative to their fundamentals, are “justified.”

To investigate the validity of such claims, this week’s chart examines the historical relationship between interest rates and equity valuations, defined as the cyclically-adjusted P/E (CAPE) ratio. If the theory holds true in practice, we would expect to see periods of heightened equity valuations coincide with low interest rates. As seen above, there are indeed periods where this relationship is observed — including today and in the late 1920’s prior to the Great Depression. However, there are also periods where the opposite is true — such as the 1910’s and during much of the 1940’s — when low interest rates accompanied low valuations. Likewise, long interest rates reached what were then all-time highs in the late 1960’s, but valuations were also heightened, challenging the assertions that are repeated today. Based on what history has shown us, we would caution against the use of long interest rates as a reliable gauge of the reasonableness of equity market valuations.

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The Sixth Fed Hike and Rising LIBOR

The Federal Reserve announced its sixth rate hike on Wednesday, with the target fed funds rate now 1.5% – 1.75%. The decision to increase rates was based on low unemployment and low inflation. Our chart this week takes a closer look at LIBOR (more formally known as the London interbank offering rate) and its relationship with the fed funds rate. As a matter of background, LIBOR is primarily used as the base rate upon which the floating rates for bank loans and private credit are set. For example, a bank loan with an L+400 rate means that it yields 400 basis points over LIBOR. As LIBOR rises, the bank loan’s yield rises.

As the chart shows, LIBOR demonstrates a strong correlation with the fed funds rate, which is the short-term interest rate controlled by the Federal Reserve. The blue line shows the rate hikes over the last three years. The purple line shows the corresponding rise in the three-month LIBOR, which is the most commonly used maturity of LIBOR for bank loans and private credit. On average, the three-month LIBOR is approximately 50 basis points higher than the fed funds rate; thus, LIBOR is currently around 2.0%.

The gray section on the right shows the fed funds rate (blue line) as projected by the fed funds rate futures curve. By applying the 50bp difference to the LIBOR curve, we can project LIBOR to approximately 2.5% for December 2018 and 3.0% for both December 2019 and December 2020. This means that we could expect a bank loan with an L+400 rate to yield about 6.5% in December 2018 and about 7.0% as of December 2019 and December 2020.

However, we must note that LIBOR is expected to be phased out by the end of 2021. In addition, the London Stock Exchange has been working on a new short-term benchmark interest rate that would replace LIBOR, and plans to launch this replacement rate in April. Marquette will continue to monitor and provide guidance on these LIBOR developments, as they will undoubtedly have an impact on how interest rates and the credit market are measured.

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