24 Jul 2015 Tempests in Teapots
Yesterday’s report that the number of Americans filing for unemployment insurance was the lowest since the early 70’s provides more evidence that the US economy is becoming stronger. Investors are becoming convinced that the Federal Reserve will soon begin raising interest rates back to levels reflective of a healthy economy.
Interest rates, or the price of money, in a free market (outside control of the Federal Reserve) are a function of supply and demand. When the demand for money is high, as it is in a strong economy, interest rates rise as lenders have more people seeking loans than they have money or desire to lend it. When economies are weak, lenders must drop rates to entice borrowers to do business with them.
The Federal Reserve uses rates to both support a healthy and growing economy as well as to control inflation (rising prices on the goods and services important to consumers), generally in the range of 2%.
The speed of this economic recovery has been slower than any period in modern US history. For this reason the Fed has been cautious not to increase rates too soon to risk constricting borrowing, investment and consumption which might send the economy back into a slowdown or recession. On the other hand, if they wait too long, they risk allowing the economy to grow too fast, increasing the risk of inflation and having to raise rates much faster than they would like. Cheap money would quickly begin chasing goods and services faster than the economy could create them, thereby sending prices and inflation up faster than the Fed could contain without crashing markets.
It is widely believed that the Fed will begin raising rates this fall. The fact that it is so widely expected is a good thing. Markets, stock and bond, do not like surprises. Virtually every investor who is paying attention understands that interest rates must go up as the economy improves, and this economy is improving. What most investors don’t understand is how little impact the increases have on their investments over time.
Over the past 30 years the Fed has increased interest rates over eight distinct periods. There were three periods where they increased only once before dropping again, and five periods of 6 or more increases over periods of time ranging from 10 months to 38 months. Given that interest rates are at historic lows and our economy is not so strong as the Fed might like it to be, the last period beginning June 2004 and running through September 2007 with 17 increases over 38 months is likely most similar to what we will experience going forward, although there is no way of knowing.
In every period there were countless other factors than merely interest rates working on markets to boost them or bring them down. World events, surprising earnings announcements from major market components, regulatory changes, political shifts, and a host of other factors serve to move markets.
But since interest rates are now front and center, we thought it would be helpful to take a look at how two of our model portfolios performed during past periods of Federal Reserve rate increases. Of course, past results do not guarantee future results, but history can be instructive. As we get into the numbers, I’d like to thank Ron Madey of Wealthcare for recently suggesting in a paper, the framework of comparison used here. The data come from the Federal Reserve, Center for Research in Security Prices – Chicago School of Business, and Wealthcare.
I know that charts and tables turn many of our readers off, so I apologize in advance. But please push through them because they tell an important and compelling story. The period suggested as the most similar to where we are now – June 04 – September 07 – is highlighted in yellow. The interest rate hikes start from a low of 1% and run 38 months to peak at 5.25%. But once again, each period in history has its own set of unique and multiple forces impacting the movement of markets, so isolation of just one variable (in this case interest rates) is impossible.
The table above represents the eight rate hikes over the last 30 years – when they started, ended, how many months they lasted, and what happened to rates. On the right you can see the impact in the first month of the rate increases on the three major asset components of two of our most used model portfolios: Balanced Income (BI) and Balanced (BB). The BI is 45% stocks and 50% Treasurys while the BB is 60% stocks and 37% Treasurys. The three components consist of the 7-10 year US Treasury index, the Total US Stock Market and the FTSE Global Equity market (excluding US).
A quick glance above right reveals that both the Treasurys and US Stocks were mostly down in the first month, while international stocks were up six months out of the eight. The model portfolios on the far right were up as many times as they were down and demonstrated lower losses than the higher of the stocks’ or bonds’ losses during the period.
A year later, the story is dramatically different in every case for the model portfolios with some gains in the high 30’s. As mentioned, the yellow line at the bottom represents the period most like ours now. Look how remarkably consistent those two portfolios behaved the year following the increase in June ’04. It’s also helpful to note that during the complete three-year period from June ’04 to September ’07 the BI averaged 8.7% and the BB averaged 8.1% annual returns through 17 separate rate hikes that took interest rates from 1% to 5.25%. Individually, the 7-10 year Treasury index was up 4.8% while domestic stocks were up 12.6%.
Historically speaking, Fed Rate hikes have essentially been non-events for holders of well-allocated portfolios. When you hear the talking – squawking heads on the financial programs warning about getting out of the way of the coming interest rate hikes, please see them for what they are: ‘tempests in teapots.’
