Posted by D. Laidlaw on January 11th, 2016
The world witnessed two extraordinary “liftoffs” at the end of the past year. The first liftoff was a technological advance. Space X and Blue Origin, independent aerospace companies backed by billionaires Elon Musk and Jeff Bezos respectively, were able to launch rockets which then landed intact. This advance makes rockets reusable rather than disposable and thus enables a huge leap in the efficiency of future space delivery and exploration.
The second liftoff was figurative and relates to finance and the economy. This liftoff refers to the Federal Reserve’s (Fed) decision to raise short-term interest rates for the first time in nine years. In response to the financial crisis, the Federal Reserve lowered interest rates to the zero bound in late 2008. On December 16th, the Fed increased its target rate to 0.25%.
The Fed is tasked with a dual mandate of keeping prices stable and maintaining employment. The consensus thinking is that the employment growth has been strong enough to spark future inflation. Therefore, the Fed raised rates so that higher wages do not cause inflation to spike in response to a tighter labor market.
Higher interest rates will have two different effects. The first impact, which is unambiguously positive, is that investors will receive higher interest payments on their savings. Savers have received almost no interest on short-term fixed income or money market investments for the past seven or eight years. The impact of the first couple of rate rises will be negligible. For example, an increase of 0.25% only translates to $250 in extra cash flow per year for every $100,000 in capital. However, it is expected that the Fed will increase rates throughout the coming years to keep inflation in check.
The second impact of higher interest rates is less salutary. Theoretically, higher interest rates should translate to lower asset prices for any financial asset that produces cash flows. This connection for bonds is very direct: increasing rates cause lower prices for bonds since the income stream from bonds is discounted at a greater rate. Therefore, bonds decrease in price because future interest payments are less valuable.
The connection between interest rates and stocks is less direct. Most stocks pay dividends and, similar to bonds, this stream of dividends and cash flows is worth less than it would be in a lower rate environment. On the other hand, interest rates are rising due to the strength of the underlying economy. A stronger economy means that companies will be selling more goods and services which entails higher revenues and higher earnings. Similarly, underlying growth could be higher in an inflationary environment for companies that are able to pass along higher prices.
We expect that interest rate increases will be extremely gradual for two reasons. The US economy is growing, but the rate of growth isquite slow and the Fed recognizes that a stronger dollar hurts our export economy. There also does not appear to be any catalysts that would suggest that significantly faster economic growth is at hand. To the contrary, the greatest threat to continued expansion in the US is still economic weakness abroad. China’s manufacturing sector shows no signs of recovery as recent statistics indicate that manufacturing has declined for the past 10 months. The US economy is diversified; however, it is unlikely that we will be able to remain sheltered from the world’s malaise indefinitely.
The Fed will also be reluctant to raise rates too aggressively in an election year. It is important for the Fed to maintain its political independence from either party and it will try hard not to be viewed as favoring either side by its actions.
Almost all asset classes provided no real returns in 2015. The S&P 500 produced a total return of 1.38% which is below its dividend yield. Foreign stocks declined by -5.7% (MSCI All Country World Index Ex-US). The aggregate bond market advanced 0.55% while weak credits declined in value. Finally, commodities were the poorest performing asset class with prices for oil (-30.5%), gold (-10.4%) and other commodities all falling substantially throughout the year.
Our expectations for fixed-income returns are muted given that interest rates will most likely rise modestly from current levels as discussed above. We plan on maintaining short duration high quality fixed-income investments to avoid credit issues that are rampant in the energy sector and corners of the municipal market such as Puerto Rico.
We view the potential for stocks more favorably than bonds given that profits are healthy outside of the energy sector. Consumers have also yet to spend their gasoline and home heating savings so there may be an uptick in domestic spending.
The liftoff for the current long-running bull market began in March of 2009. Stocks have advanced with notable slowdowns in 2011 and last year. Overall, the interest rate increases are a positive development since lenders/savers should be able to obtain higher interest rates without a spike in rates that jeopardizes stock valuations.
Investment Process Notes
A vital piece of our investment process involves an analysis of the sustainability of the underlying businesses of the stocks that we hold in portfolios. A component of this sustainability is whether or not customers of a given company’s product or service are deriving a true benefit for an appropriate price. We favor companies that deliver value to their customers since those companies will have longer lasting businesses with less risk. One of our new colleagues, Nick Frelinghuysen, examines this aspect in a short piece related to pricing within the health care field.
Ben Connard examines a different investment question in the last section of this commentary. His issue addresses whether to hold or sell a position that has performed poorly after purchase. We explore these issues to shed light on the thinking that informs our investment decision-making.