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4/7/2016 How Rising Interest Rates Will Affect The Stock Market And Your Investments Forbes
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How Rising Interest Rates Will AffectThe Stock Market And YourInvestmentsThe benchmark interest rate, known as thefederal funds rate, has been set at a record low of0.25% since December 2008. It’s hard to imaginethat the it averaged 6% since 1971 and soared ashigh as 20% in 1980. The Federal Reserve isexpected to raise interest rates eventually when itbelieves the U.S. economy can stand on its ownwithout stimulus. The effects of rising interestrates will ripple through stock markets aroundthe world.
Robert R. Johnson explains in his new book,Invest with the Fed, released in March byMcGraw Hill, how investors should prepare theirportfolios for changes in Federal Reservepolicies. Johnson, Ph.D., CFA, CAIA, serves aspresident and CEO of The American College ofFinancial Services in Bryn Mawr, Penn.
Ho: When do you expect the Federal Reserve toraise interest rates? Under what conditionswould they do so?
Johnson: The Fed doesn’t want to forestall theeconomic recovery by prematurely raisinginterest rates. While I am not in the business ofpredicting Fed actions, I expect the Fed tocontinue to exercise patience and maintain thecurrent near zero interest rate policy until theysee a clear indication of accelerating economicgrowth.
Ky Trang Ho Contributor
I cover investing strategies and trends in ETFs and mutual funds.
Opinions expressed by Forbes Contributors are their own.
4/7/2016 How Rising Interest Rates Will Affect The Stock Market And Your Investments Forbes
http://www.forbes.com/sites/trangho/2015/05/19/howrisinginterestrateswillaffectthestockmarketandyourinvestments/print/ 2/7
The earliest warning could come at the end ofJuly when estimates from the secondquartergross domestic product, GDP, are released by theU.S. Department of Commerce. I suppose, theFed could announce an increase at the July orSeptember Federal Open Market Committeemeetings, but that is highly unlikely. I believe,that absent unexpectedly strong economicgrowth, the inevitable increase in rates will likelynot happen until early 2016.
Robert R. Johnson, Ph.D., CFA, CAIA, is president and CEO of TheAmerican College of Financial Services in Bryn Mawr, Penn., andauthor of “Invest with the Fed.” (Robert Johnson)
Ho: How do you expect the stock market toreact?
Johnson: The market will likely react verynegatively in the shortterm and continue toperform poorly over the longterm. Some punditsare claiming that the market may view a rate hikeas positive for the stock market because it signalsthat the Fed believes the economy is sound. Idisagree.
The research presented in Invest With The Fedshows that longterm stock market performancehas been dramatically better in expansivemonetary policy environments than in restrictivemonetary policy environments. Expansivemonetary environments are defined as thoseperiods during which the Fed is lowering rates. Alternatively, restrictive monetary environmentsare when the Fed is raising rates.
4/7/2016 How Rising Interest Rates Will Affect The Stock Market And Your Investments Forbes
http://www.forbes.com/sites/trangho/2015/05/19/howrisinginterestrateswillaffectthestockmarketandyourinvestments/print/ 3/7
Over a 48year period from 1966 through 2013,the S&P 500 (SPY) returned 15.18% duringexpansive periods and only 5.89% duringrestrictive periods. The Fed was expansive andrestrictive about the same amount of time. Oneof the most interesting findings of our research isthat stock market returns are not as correlatedwith the level of interest rates (whether rates arehigh or low) as they are with the direction ofinterest rates (whether rates are trending up ordown).
Ho: What implications would Fed policy changeshave for various asset classes: value and growthstocks, real estate, fixedincome, etc.? (Thelargest ETFs tracking these asset classes areiShares Russell 1000 Value ETF (IWD), iSharesRussell 1000 Growth ETF (IWG), VanguardREIT ETF (VNQ), Vanguard Total Bond MarketETF (BND).
Johnson: The welldocumented value effect ishighly concentrated in expansive Fed monetarypolicy periods. When the Fed is raising interestrates, there is little difference in performancebetween value and growth styles. In fact, bothvalue and growth suffer and have about the samereturn.
The same is true for the small firm effect. Smallfirms perform dramatically better than largefirms during expansive monetary policy periods,yet there is very little performance differenceduring restrictive periods.
One popular investment approach based onbehavioral finance is a “reversals” strategy. Thatis buying downtrodden stocks and selling stocksthat have recently outperformed. A great deal ofevidence has been presented that shows thatyesterday’s losers are indeed tomorrow’swinners. With respect to monetary policy, wefind that such a strategy works markedly betterin expansive monetary policy periods versusrestrictive periods.
Real estate – as proxied by Real EstateInvestment Trusts (REITs) – are a poorperformer when rates are rising. Both equity andmortgage REITs perform much better duringexpansive monetary policy environments.However, mortgage REITs perform particularlypoorly when rates rise.
4/7/2016 How Rising Interest Rates Will Affect The Stock Market And Your Investments Forbes
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Federal Funds Rate Percentage from 1971 to 2015 (Courtesy:TradingEconomics.com)
We have all been taught that internationaldiversification will provide stability to ourportfolios. Unfortunately, with respect to Fedmonetary policy, international developedmarkets (EFA) follow the same return pattern asU.S. markets and offer little diversificationbenefit when investors need it most. I believethat this is because most major financial marketsare increasingly globally integrated and globalcentral banks often following similar interest ratepolicies.
The good news for investors is that emergingmarkets (EEM) and frontier markets (FM) haveexhibited a very different pattern with respect toFed monetary policy. Emerging and frontiermarkets have performed much better when theFed has been restrictive than expansive. I wouldcaution that this evidence is based on a muchshorter sample period than the nearly halfcentury period for the traditional asset classes.
The data on returns to hedge funds is limited to arelatively short time period. But, when you lookat the performance of several hedge fundstrategies that many hedge funds follow, you findthat the success of those strategies almostexclusively depends on the monetaryenvironment. When Fed policy is expansive, theperformance of those strategies is oftenexceptional, but the strategies perform poorlywhen the Fed is restrictive.
Fixedincome securities tell a bit of a differentstory. Specifically, the returns to U.S. Treasurybonds (TLT) have been relatively invariant tomonetary policy conditions. On the other hand,highyield bonds (JNK) have performed muchbetter during expansive monetary conditionsthan in restrictive conditions. This isn’tsurprising, given that junk bonds are considereda hybrid between straight debt and equity
4/7/2016 How Rising Interest Rates Will Affect The Stock Market And Your Investments Forbes
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securities. The better performance duringexpansive periods is a reflection of the equityelement of junk bonds.
“Invest with the Fed” book cover (Courtesy: McGraw Hill)
Ho: What stock market sectors would benefitmost in a rising interest rate environment?
Johnson: The evidence is clear that it paysinvestors to change their equity sector allocationdepending upon Fed actions. When the Fed isrestrictive the sectors that perform best includeenergy (XLE), consumer goods (XLY), utilities(XLU), food (PBJ) and steel products (SLX). This makes sense as these sectors producenecessity goods that have less reliance on thedisposal income of consumers.
When the Fed is expansive, the leading gainershave been apparel, retail (RTH) and auto stocks(CARZ) – sectors that are highly dependent uponconsumer discretionary spending. When the Fedis pumping more liquidity into the markets, thesefirms thrive.
Ho: How do you expect commodities, and inparticular precious metals, to perform as interestrates rise?
4/7/2016 How Rising Interest Rates Will Affect The Stock Market And Your Investments Forbes
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Johnson: A broad basket of commodities (DJP)perform much better during restrictive monetarypolicy environments – offering investors a realalternative to stocks during rising interest rateperiods. Commodities are investment vehiclesthat offer great diversification potential withrespect to Fed monetary policy. We find thatthey do indeed zig when the market zags. TheGoldman Sachs Commodity Index (GSCI) had areturn of 0.19% annually during expansiveperiods, while the return during restrictiveperiods was a robust 17.66%. A greatercommodity exposure during restrictive monetarypolicy periods makes good sense.
Contrary to conventional wisdom, gold (GLD),which is often viewed as a hedge againstinflation, doesn’t perform particularly well whenthe Fed exercises monetary restraint. Thereturns to gold are quite pedestrian in bothexpansive and restrictive monetaryenvironments. Investors should not expect goldto buoy their portfolios as rates rise. As an aside,our findings show that during most periods, goldand precious metals mining stocks (XME) havebetter returns than physical gold.
Ho: How should investors position theirportfolios when the Fed raises rates?
Johnson: I am not in favor of investors makingwholesale changes to their portfolios as a resultof Fed policy changes. I do, however, believe thatcertain adjustments are warranted. For instance,I would certainly not suggest that investors tradetheir entire equity allocation for commoditieswhen the Fed raises rates. However, I do believeit is prudent for investors to lessen their domesticequity allocations when a rate increase isimminent and perhaps increase their commodityand emerging market allocations.
It also makes sense to adjust equity holdings –moving from sectors reliant on consumerdiscretionary spending to more defensive sectors– when the Fed raises rates. What is clear is thatstock market investors should, in general, adjusttheir return expectations downward during risinginterest rate environments. It is clear that theFed has a strong influence on investmentreturns. I believe that investors ignore Fed policyat their own peril.
4/7/2016 How Rising Interest Rates Will Affect The Stock Market And Your Investments Forbes
http://www.forbes.com/sites/trangho/2015/05/19/howrisinginterestrateswillaffectthestockmarketandyourinvestments/print/ 7/7
This article is available online at: http://onforb.es/1HsfwN5 2016 Forbes.com LLC™ All Rights Reserved
Ky Trang Ho is the founder of Key FinancialMedia LLC, which produces content and thoughtleadership for financial advisors and investmentstrategists.
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