Now that the US Federal Reserve is starting to cut back on its monthly bond purchases, investors are anticipating interest rates to return to normal.
Despite the nervousness in the markets on Tuesday, the US stock and bond markets took very different views on the significance of this future shift.
On Wednesday, the Fed announced that it would end its economic stimulus strategy of buying US $ 120 billion in bonds each month, reducing its purchases by US $ 15 billion per month in November and December. At this rate, the program will end in mid-2022.
The stock market immediately reacted with records at all levels. The S&P 500 gained 29.92 points to close at 4660.57, a gain of 0.65%, while the Russell 2000 small-cap equity index jumped 42.42 points to close at 2404.28, a gain of 1.8%.
Meanwhile, most sectors of the bond markets fell, with the exception of long-term Treasuries. The benchmark 10-year Treasury bill fell to 97/232, pushing the yield up 0.031 percentage point to 1.58%.
“The question is, who is going to be right? Is it the equity market that says one thing or the interest rate market that says another, ”says Hans Olsen, chief investment officer at Fiduciary Trust Co., or FTC, a $ 20 billion wealth management firm. based in Boston and serving high net worth clients across the country.
Penta recently spoke with Olsen about the changing rate landscape and what it may mean for investors.
While stock markets have generally risen, there are signs that investors are starting to anticipate a different environment, when rates will “normalize” and no longer be artificially low.
A sign is found in what is known as the S&P 500 Equal Weight Index, which gives equal weight to the 500 companies, unlike the real index, which is weighted by market capitalization. The equally weighted index has consistently indicated that the average stock is outperforming the big tech companies that dominate the index.
“We’re starting to see a rotation happening inside the market, where it’s expanding from the technology,” Olsen said. “It’s the market that recognizes that as we get rates normalized, those very long-lived stocks that weigh heavily on growth [and] have little income are redesigned.
As rates rise, “growth-oriented firms become more vulnerable” and higher-quality firms with more consistent profits begin to generate interest, he says.
This trend is also evident in the so-called Russell 2000 Quality Factor Total Return Index, which tracks stocks with strong earnings and profitability. These stocks are starting to outperform the overall index, which is filled with “no income,” says Olsen.
This shift to quality “is a function of the normalization of rates that is manifested in the stock markets,” he says.
While people rightly worry about whether the stock markets can continue to rise, the shift to quality means “that there is always an opportunity within these markets to make money in a way. more refined than before, ”says Olsen.
A return to the 60-40 portfolios?
The traditional model portfolio was invested 60% in stocks and 40% in bonds. Today, this configuration makes little sense to investors, because investing in bonds “dissipates purchasing power,” he says.
Olsen points to data showing negative returns almost everywhere in bond markets, with the Barclays Bloomberg Global Aggregate Bond Index down 4.3% for the year to end of October, and US Treasuries falling 6.1%.
The FTC has recommended that its clients consider private debt as an alternative, or structured securities, such as bonds backed by auto loans and credit card payments, or certain mortgage backed securities. These bonds offer “good credit support” and “a real rate of return on return,” says Olsen.
The only categories with positive returns for the year so far are Global High Yield Bonds (up 1.16%) and Global Inflation-Linked Bonds (up 2.51%), the latter indicating that the market thinks the Fed is wrong about inflation and should be rate lifting, he said.
If rates return to normal, the choice will fall to the bond markets, meaning that investors will once again be able to consider a range of fixed income securities, including quality corporate bonds and junk bonds. And, maybe one day the 60-40 portfolio will make sense again.
The question of inflation
Whether the signs of inflation evident in today’s economy are lasting or not will influence the Fed’s decision to raise rates after cutting its bond purchases. Although the central bank may first consider reducing its balance sheet, which has swelled to more than $ 8 trillion, says Olsen.
He sees signs that inflation will be sticky, which will justify rate hikes. This is in part because of wage pressures caused by supply chain disruptions still resulting from the pandemic. Nominal average hourly earnings for truck drivers and warehouse workers, all of whom make it easy to move goods from one place to another, are at their highest level in three years. Likewise, the wages of employees in the leisure and hospitality sectors are at their highest for three years.
These levels indicate what economists called the “reservation wage,” which is the level of compensation workers need to overcome their job reservation.
“What happened is that the additional employment benefits, however well-intentioned they were, had the side effect of increasing the reserve wage,” says Olsen.
At the same time, research from the Federal Reserve Bank of Atlanta indicates that these salary increases and rising transportation costs are “sticky,” says Olsen.
Increase in rates
At this point, Olsen thinks there’s a 60% chance the Fed will raise rates that have hovered near zero since March 2020 at least once or twice in the latter part of the year. There’s also a 40% chance that hikes will be delayed, he says.
A rate hike will occur “if [the Fed] ends the taper in the middle of the year as expected, then inflation remains stubbornly high, ”Olsen said. It will also depend on how the markets react to rate hikes, as the Fed is keen to keep the markets in order.
Olsen describes the fourth quarter of 2018 as potentially enlightening. Then the Fed had reached the point of a 0.5 percentage point hike in rates and the markets protested strongly. As a result, “the Fed gave in and basically reversed itself,” he says. “It will be interesting to see if that happens this time or not. ”
Olsen’s message to long-term investors is to hang on to what could be a period of market volatility.
“To get to the other side with a more normalized rate environment with market-determined interest rates and choice, we’ll have to go through the ‘valley of volatility’,” Olsen said. “Going to the other side is worth it, but we’re going to have to live with it, so don’t cut and run.”