While Donald Trump and his tweets continue to dominate the news, investors should not lose their focus on the Federal Reserve. Yesterday – the day before Groundhog Day – the Fed held steady on interest rates. In essence, Janet Yellen and the Open Market Committee poked their heads out, surveyed the landscape, and kept rates unchanged. For those hoping for higher rates, there will be six more weeks of interest rate winter.
This inaction was on the heels of the 25 basis point hike in the benchmark target fed funds rate announced last month. At that time, the Fed signaled that there would likely be three separate 25 basis point increases in interest rates in 2017. What does this recent inaction mean for investors?
Unless something unforeseen derails the economic recovery, interest rates are going to rise in the future. This is bad news for holders of existing bonds. When interest rates rise, the value of bonds fall. But, not all bonds are created equally. The value of long-term (long duration) bonds suffer more than shorter duration bonds when rates rise. Therefore, for those investors who believe the equity markets are overvalued, long-term bonds do not present an attractive alternative.
While the equity markets may seem overvalued on fundamental metrics such as price-to-earnings ratios, this is not deterring many investment icons from committing capital to the equity markets. In a recent interview with Charlie Rose, the Oracle of Omaha Warren Buffett indicated that he had purchased $12 billion in stocks since the election. That bit of news may give pause to those pundits who are anticipating that the Trump Presidency will cause equity prices to fall. George Soros certainly lost big on his bet that markets would tumble following Trump’s win. It seems that betting against Trump has been a losing proposition.
There may be justification for some caution, however, around “bond proxy” stocks as rates increase. With P/E ratios at the high end of the range for some of these dividend stalwarts, the risk is that as long-term bond rates rise, those who are using these stocks for current income may transition some of their funds to more traditional fixed-income vehicles.
In addition, the equity markets overall face a couple of significant headwinds. First, the initial two years of a President’s term has historically seen lower equity returns than the final two years. Legendary Barron’s columnist Alan Abelson suggested that presidents are “keen on getting the ugly stuff out of the way early in their tenure so they can act expansively the rest of the way.” In other words, they get their economic house in order in time to be re-elected.
Second, equity markets have historically performed weaker when interest rates were rising than when rates were falling. In Invest With the Fed, Gerald Jensen of Creighton University, Luis Garcia-Feijoo of Florida Atlantic University and I found that from 1966 through 2013, the S&P returned 15.2% annually when rates were falling and only 5.9% when rates were rising.
Equity investors should lower their return expectations, as interest rates are likely to rise for the foreseeable future. While rising rates are generally bad news for stocks, certain sectors perform better than others in a rising rate environment. Investors may want to overweight energy, consumer goods, utilities and food. Fixating on Trump may be both entertaining and frustrating. But, investors would be wise to monitor Fed actions. Failing to do so might just be hazardous to one’s wealth.