The End of an Era: Where to Invest When Interest Rates Rise.

April 17, 2014

On October 1, 2008, the tectonic plates of the financial world were violently shifting. The American financial system, not to mention the world's largest economy, was imploding.
Desperate times? Desperate measures.
On November 25, the Federal Reserve Board announced the onset of quantitative easing (QE1). The following day, the rate on ten-year U.S. government bonds dropped below three percent. The first such time since the 1950s. Rates have remained below three percent since. Through QE2. Operation Twist. QE3.
As Chairwoman Janet Yellen assumed the helm, the Fed appeared to assume a new mandate. While continuing to endeavor towards maximum employment and stable inflation, the U.S. central bank would now have to put the vehicle into reverse and back out of the very route we'd sped down these last five years. Only, it would have to do so at night. Without lights. Blindfolded.
Today, investors are understandably nervous. While record-low rates have buoyed the stock market, many have not participated. Now, just as they're dipping their toes in, they hear that the lifeguard plans to drain the pool.
Global investors are weary of the impact rising rates will have on stocks. Bonds. And other financial instruments.
There will always exist divergent opinions on all matters involving health and wealth. Where rising interest rates are concerned, there exists a much darker school of thought. One that foresees large equity declines as the Fed attempts to unwind its zero interest rate policy (ZIRP).
That thesis holds that equity market valuations have risen due to the Fed's liquidity injections. But, as QE ends, that liquidity will dry up. The tidal currents of cash, much of which has found its way to Wall Street, will cease to flow. Causing stock prices to revert to the more traditional paradigm of earnings growth and multiples. With economic growth lagging, and short-term multiples not expected to expand much, stocks could be in trouble.
Some of that story line has credence. But, we believe the road ahead will be more straightforward. That does not mean it will lack volatility. As interest rates rise, there will be panicked sell offs, leading to stock market declines.
Yet, as investors begin to understand that rising interest rates correlates to stronger economic growth, markets will calm. Because rising rate periods have traditionally been positive for stocks. But, investors will still need to steel themselves initially against what will be an aversion to change.
So, let's consider the road ahead.
Today, the Fed continues to taper its bond purchases. And it openly discusses the onset of rate hikes. Yet, investors must understand that, for two reasons, interest rates will not jump much.
First, the federal government remains uncertain as to the extent of the economic recovery. While most of the data continues plodding ever-so-slowly upward, the impression remains that this ship could instantly spring a leak. So the Fed, and all of those with the Fed's ear, will hesitate to send rates rashly higher, and risk undoing the last six year's progress.
Secondly, the federal government cannot afford to pay normal interest rates on the national debt. Because that debt, now approaching $18 trillion, is too big. Net interest payments currently run around $220 billion per year. That translates to a 1.9 percent average interest rate on the debt. Were rates to double, that would add another $220 billion to the deficit. Further, if the interest increased to five percent, a level at which ten-year bonds have rested for most of the last fifty years, the interest payments would accrue to an additional $360 billion per year. A significant addition to the debt and deficit.
Consequently, the U.S. government will pressure the Fed to keep rates low enough to handle until the deficit is lower or inflation has reduced the debt in real terms. And since neither appears likely soon, any near-term rate rise (2015? 2016?) will not amount to much.
So we must consider, how will rising rates impact investors?
Bond investors, those unlucky income-seekers (retirees) who have already had sand kicked in their faces by the current low-rate regime, will once again absorb the brunt of the blow. Ironic how the system has penalized those who played by the rules.
Worst hit will be bonds, specifically bond funds, with long maturities (duration) and low coupons. These will be most vulnerable to price declines as they are most sensitive to rising rates.
Fixed-income investors must consider shortening their maturities - anything under five years will suffice, while raising their coupons. Higher rates can most easily be found among less-than-investment-grade bonds. High-yield (junk) bonds issued by companies rated as less than triple B.
Fixed-income investors should also consider an allocation towards senior-loan portfolios. These are secured by a company's assets and so lower in risk, even as most are issued by companies with below investment grade credit. Additionally, as floating rate loans, they pay a spread over some benchmark rate, like LIBOR. As interest rates rise, the yields on senior loans increase while the value of the investment portfolio remains stable. So providing the benefit of high yields and protection against rising rates.
Finally, fixed income investors will do well to consider very short term Treasuries. While coupons are low, so are durations. Providing the ability to reinvest into rising interest rates.
As for equity investors, there too you'll find winners and losers.
Cash-rich companies, those who have been hoarding capital since 2008, will be in a position to earn higher yields on their cash and equivalents, so increasing profits.
We've identified select property-and-casualty insurers that will benefit by their enormous "floats," the cash reserves that result from the collection of monthly insurance premiums that have not been paid out as claims. Even better, insurance premiums have been increasing, and typically continue upwards as inflation begins to rise.
Payroll processors will also benefit -- though by a different kind of float. The trend in business outsourcing has skyrocketed. And will only continue. Businesses outsource their payroll services to national processors. These processors may serve a half-million employees or more. Each month, there is a lag time between the date they receive payroll money and the date that they issue paychecks. They have the ability to invest those short-term funds. And reap the rewards.
Yet, it will not only be financial service companies that prosper.
As interest rates rise, technology manufacturers traditionally sell more hardware and software. This due to businesses and individual consumers increasing their technology spending against the backdrop of an improving economy. Like insurance and payroll peers, the largest technology companies also have the ability to accumulate massive cash hoards. On which they can earn higher interest payments as rates rise.
Apple holds $145 billion in cash. Microsoft sits on $75 billion. And Cisco Systems, $45 billion.
Of course, sometimes rising rates bring inflation. So investors will wish to protect portfolios against both. How better to do so than by utilizing futures and other derivatives that enable them to bet against falling bond prices. Or, how about the exchange on which these derivatives trade?
CME Group (CME) owns the Chicago Mercantile Exchange, the nation's largest futures trading floor. Increased trading volume and heightened interest will add to CME's bottom line.
Finally, brokerage and banking stocks tend to perform as well as any other sector during the initial phases of interest rate increases. Companies like Charles Schwab (SCHW), TDAmeritrade (AMTD) and Wells Fargo (WFC) profit from the growing spread between the short-term interest rates paid to depositors and the long-term rates collected on loans. Additionally, online brokerages will see bond fund outflows reallocated to stock portfolios. So enhancing financial advisory and trading fees.
As potential home buyers realize that fixed-mortgages and housing prices are likely to rise, more will jump into the housing markets. So, companies in the mortgage lending business, like Wells Fargo, should benefit from a rising demand for mortgage loans, helping to offset the drop in refinancing fees.
Of course, not all stocks will be so amenable to rising rates.
Highly leveraged businesses like telecommunications companies, utilities and real estate investment trusts (REITs) may suffer. Only because they'll need to acquire substantial debt to support expansion.
In fact, REITs are legally prohibited from retaining more than 10 percent of earnings. Making them heavily dependent on loans as they acquire properties. Rising rates will increase their debt burdens, cut profitability and hurt stock prices.
Moreover, beware those traditional blue chip companies in which investors have become so enamored. Given their rich dividends, investors have moved en masse into these companies as an alternatives source of fixed income the last five years. Consistent cash flow and lower volatility enhance the attraction. But today, many of these stocks are overvalued. And their dividends compare less favorably to risk-free Treasuries. As fixed-income yields rise, these blue chip dividend stocks will likely re-calibrate as investors grapple with less attractive dividends, less attractive comparisons and elevated valuations.
Other losers? You'll want to avoid companies that rely on low-cost loans to spur consumer demand. Think auto manufacturers. Home builders. As interest rates rise, these concerns will see less demand and lower profits. As both of industries have incurred run ups the last two years, that could further catalyze investor urgency to take profits.
Socrates counseled, "The only true wisdom is in knowing you know nothing."
Given the speculation surrounding the future of interest rates, one thing is evident. Rates will rise. And nobody knows with certainty how investors and the market will respond. The smart money will have a plan. And will be proactive in its execution. Those who sit and hope for the best will pay through the degradation of their investment capital.
Otherwise, we're happy to discuss this in person or by phone. Because we believe that the end of the Fed's zero interest rate policy will be one of the most impactful events investors will confront these next few years. We don't know when it will transpire, nor its precise impact. Still, I don't know when my next fender bender will occur. Yet I still buy auto insurance.
Remember, astute investors do not attempt to predict the future. They assess possible outcomes. Game plan for the most likely. And hedge against the worst cases. It is less forecasting than it is planning and preparation.
Rising rates will not likely bring the stock market cataclysm that some predict. But, like all major shifts in economic policy, it will impact a number of asset classes. Positively and negatively. If you're not prepared for those changes, then you're not investing. You're playing Russian Roulette.

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