Quarterly Review & Outlook – 3rd Quarter 2018

Rates are about to soar – or maybe not

Investors got a little spooked in early October as fears over rising interest rates became a bit overwrought and stocks sold off in response. As of this writing, it is not clear when the correction will subside and buyers-on-the-dip will step in, but so far it feels like a typical (but lately infrequent) pullback and consolidation. The proximate cause was confirmation from the Federal Reserve that more interest rate hikes are likely in the offing, implying somewhat lower future valuations for equities in the months and years ahead. And of course, rate hikes are always accompanied by speculation regarding how high the cost of money can rise before the economy begins to feel the pain.

While we generally recommend tuning out anyone who posits that “this time is different”, it is worth considering that at least some significant determinants of the level of rates have shifted over the past three decades, and that in fact the equilibrium level of interest rates may indeed be significantly lower than generally assumed. This would be good news for stocks, more about which below.

US domestic equity markets for the most part continued their upward march in the third quarter of the year. The broad S&P 500 index gained 7.7 percent and is up over 10 percent year to date, while the Dow Jones Industrial Average picked up 9.6%, moving out of negative territory for the year. Technology-based issues continued to advance, with the NASDAQ Composite up 7.1 percent for the quarter and a whopping 16.5 percent for 2018 to date. Growth stocks continue to trounce value, with a differential of around 13 percentage points for the year. Value investors have seen this movie before, as the pattern in 2018 is eerily (and painfully) similar to 2017 and 2016.

International stocks continue to struggle in light of slowing global growth and a weakening Chinese market, difficulties at least partially attendant to the ongoing and potentially worsening trade war launched by the US. The developed-market EAFE index gained a paltry 1.4 percent and remains in the red for the year. The emerging markets (including China and India) gave up around 1 percent for the quarter and is still 7.7 percent underwater for 2018 through September.

The US economy continues to “fire on all cylinders” according to Charles Evans, President of the Chicago Fed. Certainly the second quarter showed remarkable strength, with GDP growing at an annualized clip of 4.2%, the strongest rate in nearly 4 years. Unemployment currently sits at a nearly 50-year low of 3.7 percent, well below the level economists generally consider to be “full employment”. It’s all systems go at the moment, and consensus estimates for third quarter growth continue to exceed 3 percent (with the Atlanta Fed model knocking on the door of 4 percent). Anecdotal evidence of labor shortages comports with Labor Department job openings data.

Meanwhile, corporate earnings growth has spiked in part due to the reduction in corporate taxes provided by the Tax Cuts and Jobs Act enacted last December. Consumer confidence stands at multi-year highs as well, and investors have demonstrated a distinct appetite for risk. All of which supports the robust growth in US equity values, especially the growth or momentum stocks including the usual suspects like Netflix, Apple, Google and Microsoft. What’s not to like?

Well, as the past two weeks have demonstrated, Goldilocks doesn’t stay in one bed for long. Interest rates have been inching higher since the historic trough in July of 2016. But recent movement has accelerated, striking fear into the hearts of equity investors on guard for the imminent return of Papa Bear. Rising rates are the inevitable consequence of economic vitality, but only to a point. Beyond a certain threshold, higher borrowing costs begin to impede the ability of businesses to raise debt capital for expansion and of consumers to finance new homes and cars, dampening demand and with it the profit growth that propels stock prices. Furthermore, the level of interest rates is the denominator in most analysts’ stock valuation models. Ceteris paribus, if rates rise, estimates of future stock prices fall as a mathematical consequence. The recent acceleration in rates sent a shiver through the equity markets, that has yet (as of this writing) to recede.

Given that background, are rising interest rates likely to signal the end of the bull market and the beginning of the next economic decline?

Perhaps not. With due humility, it just might be somewhat different this time. Consider the following.

As we discussed earlier, interest rates naturally rise as the economy heats up (think about the increase in demand for loans as growth accelerates. The interest rate is essentially the price of borrowed funds. Furthermore, the nominal interest rate includes a premium for expected inflation over the period of the loan). Up to a certain level, this incremental elevation in rates is absorbed by the growing economy, but beyond that critical point it begins to weigh on expansion and can eventually choke off growth. The interest rate that is “just right”, not too hot and not too cold, is typically called the “neutral” rate. Since the depths of the financial crisis, rates have been held below the neutral rate by the Federal Reserve in order to stimulate faster GDP expansion and actually induce incrementally higher inflation.

The Federal Reserve essentially controls the level of short-term interest rates through the so-called Fed Funds rate, a loan rate banks charge to lend excess reserves to each other. This reference rate is a key determinant of other market rates like the 1-year Treasury bond rate. The Fed cut this rate to 0.25 percent and held it there for years, only beginning the long road to normalization in December of 2015. Since then, the rate has been incrementally raised multiple times to the current 2.25 percent. Market expectations, as well as the consensus of Fed board members’ forecasts, anticipate at least another 1 to 1.5 percent increment over the next 12 months, close the to what many believe to be the neutral rate.

But is the neutral rate still 3.5 to 4 percent as most of us were taught? At least some prominent observers think perhaps not.

James Bullard, the erudite but affable President of the St. Louis Federal Reserve bank, believes we are there already. He makes an interesting case for revising the model the Fed uses to estimate the neutral rate of Fed Funds which, if he is correct, implies that the upward trajectory is shallower than believed (or feared) by the markets.

The formula for estimating the neutral rate, popularly called the Taylor Rule, dates back to a seminal 1993 paper by economist John Taylor. Leading up to the financial crisis, the rule performed reasonably well and suggested a widely supported estimate of around 4 percent for the neutral Fed Funds rate. But most economists believe some of the parameters in the equation have shifted over the past 20 years. Bullard in particular suggests three significant developments.

First, short-term interest rates after adjusting for inflation have declined to near zero. That is, the spread between government bond rates and inflation has effectively disappeared over time. Investors in risk-free assets are basically content just to maintain their purchasing power.

Second, the feedback mechanism between the real economy and inflation appears to be broken. It has long been observed that lower unemployment leads to higher inflation (the so-called Phillips Curve). This feedback loop has all but disappeared in recent years. Note that unemployment is near 50-year lows, but inflation remains stuck below the Fed’s target level.

Finally, our ability to accurately measure inflationary expectations in real time has improved significantly thanks to the advent of bonds sold by the US Treasury that adjust for inflation (known as TIPS or Treasury Inflation Protected Securities). Economists can now directly observe the market’s expectation of future inflation simply by watching the price of TIPS bonds.

Adjusting these three parameters in the classic Taylor Rule equation changes the game. The original rule suggests an estimate of 5 to 6 percent for the neutral rate by 2020. Applying Bullard’s modifications based on observation of more recent trends, the neutral rate falls to around 2 percent, very close to the current Fed Funds target rate. This warrants serious consideration.

It should be noted that most Fed members are at least on the same page as President Bullard; the consensus estimate of Fed forecasts for the neutral rate clusters around 3.2 percent for 2019 and 2020, leaving room for four additional rate hikes but significantly lower than prior belief.

Contrarians point out that the torrid pace of economic growth and evident labor shortages are certain to ignite inflationary pressure any day now. But most economists recognize the temporary nature of the GDP spurt is largely the result of an explosion in deficit spending and is not sustainable. A return to trend growth of 2.5 percent is likely once the sugar high abates, probably as early as the first quarter of 2019.

The Fed is ever vigilant in its assigned duty to monitor and combat excess inflation. Should the prevailing regime shift, with a return to the conditions under which the Taylor Rule was devised, rates will necessarily rise above current consensus projections. But barring a significant and wholly unexpected acceleration in productivity growth, it could be that interest rates don’t rise all that much more next year. Certainly not yet conventional wisdom, but worth considering. And that would be excellent news for stock investors.

Christopher A. Hopkins, CFA

© 2018 Barnett & Company


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