Topic Tags: Interest Rates

3Q15 Rate Hike and Yield Curve Flattening Expected – Marquette Associates Survey

February 2015 Investment Perspectives

Consensus among market prognosticators is that the Federal Reserve (“Fed”) will raise interest rates this year. However, there is less agreement about when rates will start to rise, as well as how the shape of the yield curve will shift as rates start to ascend. To gain a better sense of when the rate hike can be expected to begin as well as how the shape of the yield curve is expected to change, we surveyed 41 fixed income investment management firms, large and small, for their best estimates based on the current market environment. In addition, we collected responses on when to expect a major credit spread widening, i.e., when we should expect major defaults from corporate bond issuers given the re-leveraging that has taken place over the last eight quarters. We also obtained from the respondents their expectation as to which region of the world might provide the best fixed income returns in 2015.

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2015 Market Preview

January 2015

Similar to previous years, we offer our annual market preview newsletter. Each year presents new challenges to our clients, and 2015 is no different: U.S. equities are at all-time highs, uncertainty reigns for international equities, and to everyone’s surprise, interest rates fell dramatically in 2014…but are poised to rise from historic lows over the next year. In the alternative space, real estate remains a solid contributor to portfolio returns, and private equity delivered on return expectations, though dry powder is on the rise. Hedge fund results were mixed, but have shown to add value in past rising interest rate environments. Further macroeconomic items that bear watching for their potential impact on capital markets include the precipitous fall in oil prices, the strengthening U.S. dollar, job growth, and international conflicts.

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When Will Rates Rise in 2015?

As investors turn the calendar to 2015, one of the big uncertainties for the coming year is Fed policy and its impact on interest rates. In October, the Fed formally wrapped up its quantitative easing program, which saw the size of the central bank’s balance sheet grow from a pre-crisis $800 billion to almost $4.5 trillion. Now, the Fed can once again focus on the more traditional policy tool of manipulating short-term interest rates.

As investors turn the calendar to 2015, one of the big uncertainties for the coming year is Fed policy and its impact on interest rates. In October, the Fed formally wrapped up its quantitative easing program, which saw the size of the central bank’s balance sheet grow from a pre-crisis $800 billion to almost $4.5 trillion. Now, the Fed can once again focus on the more traditional policy tool of manipulating short-term interest rates. Against a backdrop of steadily improving economic fundamentals and low inflation, the Fed has pledged to keep the Fed Funds rates low for a “considerable” period of time. Investors have loosely interpreted such Fed-speak to mean that the first rate hike is likely to occur sometime in the second half of 2015.

For a more precise estimate of the market’s interpretation, we can turn to the futures market for potential guidance. As of November 28, the futures market was predicting that the effective Fed Funds rate will rise from its current level of 0.10% to 0.25% by August of 2015, reaching a level of near 0.50% by the end of 2015. Unfortunately, as our chart of the week shows, the futures market has historically been a poor predictor of future interest rates. Since the 2008 Financial Crisis, futures contracts on the effective Fed Funds rate have serially overestimated the actual level of interest rates. So while 2015 is supposed to finally be the year that interest rates rise off historic lows, the futures market cannot be counted on to accurately predict the timing and magnitude of any increase.

A Closer Look into the U.S. Job Market

On October 7th, the Bureau of Labor Statistics released the August Job Openings and Labor Turnover Survey (JOLTS), which showed that the number of job openings waiting to be filled in the United States rose to 4.84 million. The 4.84 million vacant jobs in August is the highest number of job openings in the U.S. since January 2001, and is the third highest number of job openings on record since the inception of the JOLTS survey in 2000.

On October 7th, the Bureau of Labor Statistics released the August Job Openings and Labor Turnover Survey (JOLTS), which showed that the number of job openings waiting to be filled in the United States rose to 4.84 million. The 4.84 million vacant jobs in August is the highest number of job openings in the U.S. since January 2001, and is the third highest number of job openings on record since the inception of the JOLTS survey in 2000. The number of open jobs in the U.S. grew by 910,000 for the 12 month period ending August 31, which is the largest year-over-year increase in job openings since the JOLTS survey began. The large and growing number of open jobs in the U.S. indicates that the strong employment growth experienced recently is likely to continue into 2015.

The fact that there are a near-record number of vacant jobs in the U.S. while the unemployment rate is above the long-term average is a sign that employers are having difficulty finding qualified candidates for open positions. However, if this trend continues it will eventually start to put upward pressure on wages, which could be a bit of a double-edged sword. Higher wages would be a positive development for the overall economy, as the low level of wage growth the past several years has been a significant drag on consumer spending, which is the single largest contributor to GDP in the U.S. However, increased wage growth has the potential to put upward pressure on the inflation rate, which would likely force the Fed to raise interest rates more rapidly than the market currently anticipates, and this has the potential be a drag on the equity markets.

S&P 500 Dividends and Stock Buybacks Hit Record Levels

This week’s Chart of the Week examines increases in dividends and stock buybacks for companies within the S&P 500 index during the prior six years. Following a recession low of $71.8 billion during the second quarter of 2009, combined dividend and buyback expenditures established a record high of $241.2 billion in the first quarter of 2014.

This week’s Chart of the Week examines increases in dividends and stock buybacks for companies within the S&P 500 index during the prior six years. Following a recession low of $71.8 billion during the second quarter of 2009, combined dividend and buyback expenditures established a record high of $241.2 billion in the first quarter of 2014. The previous record occurred during the third quarter of 2007 when companies spent a combined $233.2 billion on dividends and buybacks.

Stock buybacks reduce the amount of shares outstanding for a company which causes earnings per share (EPS) to increase since the same amount of earnings over fewer shares outstanding creates a higher EPS value. EPS is a metric used in the determination of stock price, so a higher EPS value provides support for the stock price to appreciate in the near term.

A significant source of funding for stock buybacks in recent years came from the ability to borrow at short-term rates near zero. As interest rates are set to eventually rise, companies will be less inclined to fund buybacks in this manner. Compared to dividends which typically don’t experience large changes from period to period, stock buybacks are more dynamic in nature and can be quickly reduced if needed. Going forward, a potential concern for future stock market returns is that if buybacks are scaled back significantly, returns will likely be adversely impacted by such a contraction in buybacks.

Portfolio Strategies for a Rising Interest Rate Environment

2014 Marquette Investment Symposium session

In this presentation from our 2014 Investment Symposium, we explore current interest rate levels, our perspective as consultants, and strategic solutions for mitigating the effects of rising rates on portfolios.

Recorded Friday, September 12, 2014
2014 Marquette Investment Symposium

Please contact us for access to this video.

Weak Loan Demand in Euro Area

Due to stagnating growth and marginal inflation in the Euro area, Mario Draghi recently announced that the European Central Bank (“ECB”) would reduce the interest rate on main refinancing operations from 0.15% to 0.05%.

Due to stagnating growth and marginal inflation in the Euro area, Mario Draghi recently announced that the European Central Bank (“ECB”) would reduce the interest rate on main refinancing operations from 0.15% to 0.05%. Reductions would also occur for the rate on the marginal lending facility from 0.40% to 0.30% and the rate on the deposit facility from -0.10% to -0.20%. In addition, the ECB will start purchasing asset backed securities in an attempt to facilitate new credit flows into the economy.

This week’s chart examines the balance sheet of euro area monetary financial institutions (“MFIs”). In particular, the chart illustrates the year-over-year growth of loans in the region. Notably, the growth rate has been negative since the end of 2012. The low lending levels are likely due to poor demand as a result of the subpar economic situation in the euro area, particularly countries on the periphery.

While yields on European government debt have tightened dramatically since Mario Draghi pledged to do whatever it takes to preserve the European Union in mid-2012, the underlying economic environment has remained challenging. The unemployment rate is currently 11.5%, the inflation rate is a paltry 0.3% and projected euro zone growth for 2014 is just 0.9%. The lack of loan demand, slack in labor markets, and overall low growth point toward the likelihood of a protracted period of low inflation.

The potential for deflation has led the ECB to initiate its most recent rate cuts and asset purchases. Similar to the effects of the Fed’s quantitative easing, markets may react favorably to the ECB balance sheet expansion, albeit at the cost of the euro currency. It is important for investors to monitor the ECB monetary policy and structural reforms that have been implemented by many euro zone countries to gauge whether they are effective in stimulating growth, and by extension, promoting positive investment returns from the region.

Real Estate: The Income/Appreciation Story

Income and appreciation are the two main components of returns to any investment, including real estate. Core real estate returns, as measured by the NCREIF Property Index (NPI), have been driven by the appreciation component over the past several years…

Income and appreciation are the two main components of returns to any investment, including real estate. Core real estate returns, as measured by the NCREIF Property Index (NPI), have been driven by the appreciation component over the past several years, and this has naturally been accompanied by a compression in capitalization rates.

In this week’s Chart of the Week, we look at the income and appreciation components of core real estate returns and how they have contributed to total returns over the past twenty years. We can see that income has historically contributed approximately 60% to the total returns of core real estate.

The income component has been below this long-term average for most of the quarterly periods since real estate’s performance returned to positive territory in 2010, as appreciation and cap-rate compression have been the main stories since the rebound from the financial crisis. However, with the expectation for a rising-rate environment on the horizon and an end to cap rate compression looming near, we anticipate that income will start to represent a larger fraction of total returns over the medium term. This should provide comfort to investors with allocations to core real estate funds and even core-plus and value-add real estate funds that have meaningful exposure to healthy, stabilized, income-generating properties.

Fixed Income, (Eventually) Rising Rates and the (Non) Universal Law of “Bond Gravity”

In describing some of the strategies and portfolio frameworks that investors could consider for the management of their duration, liquidity, and credit exposures in anticipation of rising rates, we will address the potential benefits and also highlight some likely risks that should not be overlooked.

While we cannot predict exactly when and by how much rates will rise, the Federal Reserve (“Fed”) has recently signaled that we could see a modest increase in the fed funds rate by mid-2015. Given the increased possibility of rates rising over the next few years, investors should not retreat in fear from bonds en masse or look to underweight their fixed income allocations to anemic levels. Instead, they should continue to view fixed income as strategically important: after all, fixed income is a broad asset class with a diverse opportunity set. And, while we will summarize our views on some different sub-asset classes in this paper (including floating rate bonds, non-U.S. debt and convertibles), for additional reading on non-core fixed income sub-asset classes, please refer to our previously released papers on global fixed income, emerging markets debt, high yield, and senior secured loans.

In respecting the broadness of our client base, we seek to avoid a one-size-fits-all narrative on how they could look to manage their bond allocations: some clients will be limited in their ability to access certain sub-asset classes while others will have ample room and resources to maneuver across the choice spectrum. Consequently, there are a number of prudent approaches and strategies for these different types of investors to explore as a means of hedging their interest rate risk. The key is establishing which portfolio framework or sub-asset class exposure is the best fit for their programs and in line with their circumstances, risk tolerances, and investment goals.

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Favorable Relative Valuation for U.S. Large-Cap Stocks

This week’s Chart of the Week examines the historical valuation premium of U.S. small-cap stocks (as represented by the Russell 2000 index) relative to U.S. large-cap stocks (based on the Russell 1000 index). A line above 1.0 indicates a higher relative valuation for the Russell 2000 compared to the Russell 1000. As of June 30th, 2014, the small-cap index carried an 18.7% premium relative to the large-cap index

This week’s Chart of the Week examines the historical valuation premium of U.S. small-cap stocks (as represented by the Russell 2000 index) relative to U.S. large-cap stocks (based on the Russell 1000 index). A line above 1.0 indicates a higher relative valuation for the Russell 2000 compared to the Russell 1000. As of June 30th, 2014, the small-cap index carried an 18.7% premium relative to the large-cap index. Investors should typically expect small-caps to command a larger P/E multiple relative to large-caps given that small-cap stocks tend to have higher expected earnings growth rates assigned to them. Despite this, the chart above indicates that small-caps are currently at the upper end of their historical relative valuation premium. This suggests a more favorable entry point for large-cap stocks versus small-cap stocks.

With U.S. equity markets over 5-years into the current recovery and major indices trading near all time highs, small-cap stocks are facing a few headwinds. As the Fed winds down its asset purchasing program and as the market begins to anticipate a rise in interest rates, small-cap performance will be more linked to the health of the U.S. economy and face a greater sensitivity to a rise in interest rates versus large-caps. In addition, large-cap stocks derive a larger percentage of their revenues outside of the U.S. and would be poised to benefit to a greater extent over small-caps from higher expected growth rates outside of the U.S. With relative valuation levels between small-caps and large-caps currently at a high level, a better risk/reward trade-off exists for U.S. large-cap stocks.