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Global Outlook

Danger: Watch Out For Interest Rates

April 29, 2014, Tuesday, 17:28 GMT | 12:28 EST | 20:58 IST | 23:28 SGT
Contributed by eResearch

As I indicated last week, one of my major concerns for the market regards rising interest rates. Quite simply, interest rates have been too low for too long. What do I mean by this? Well, a good way of gauging interest rates over time is to examine the yield on ten-year treasuries. The yield is the interest rate necessary to make the current price of treasuries equal the present value of future income streams an investor gets from holding the treasuries. Since 1962, the average ten-year yield has been 6.56%. Currently, the yield is 2.70%, down from 2.77% at the beginning of April.

What do we see? First, beginning around 2008 and continuing through 2012, the yield on the ten-year treasury fell from 4.63% in 2007 to a record low of 1.8%. This was a direct result of two things. First and most important was the huge recession in 2008. If you look back at the data, you see that when recessions hit, interest rates tend to go down as investors buy the safety of bonds to protect them from the recession. As investors buy bonds, the prices of bonds increase and the yields on those bonds fall.

This helps explain why interest rates fell in 2008 and 2009, but why did rates then continue to decline through 2012? The answer has to do with the reaction to the recession by the Federal Reserve.

The Federal Reserve reacted to the recession by buying ten-year treasuries, effectively pushing yields downward in an attempt to stimulate the economy. The move basically worked, and the U.S. economy as a result has fared much better than foreign economies.

What are we likely to see in the future?

On the side of keeping interest rates below historical levels, there is a massive amount of surplus capital sloshing around the global economy looking for yield, effectively keeping interest rates low. Also, wage inflation remains contained, both due to the supply of labor increasing dramatically with globalization, and increased productivity due to technological changes. Without wage inflation, we generally do not see price inflation, and price inflation is a major upward drive of nominal interest rates. The high interest rates of the 1980s were driven primarily by high inflation expectations.

Despite these fundamental factors keeping rates low, the table above shows two trends very clearly. First, rates are lower than what they have been historically and, second, they seem to have bottomed around 2012. We can argue about the pace of interest rate increases but, at the end of the day, the Federal Reserve needs eventually to stop buying bonds as there is a limit to how big their balance sheet can inflate. As the Federal Reserve stops buying bonds and as the economy continues to recover, and investors are less fearful, interest rates are going to move upward toward historical levels.

Additionally, if you analyze interest rates over time, what you find is that changes in interest rates show a relatively strong degree of serial correlation. What this means is that. if rates rose last year, it is likely to rise again next year, similarly, if rates fell last year, they are likely to fall again this year. Interest rates have already begun to rise and, most importantly, current interest rates are very far below their historical average.

We are left with a very good prediction that interest rates are likely headed higher over the next few years as the Federal Reserve gradually ends its bond buying.

Well what will happen to stocks?

To answer this question, it really helps to look what has happened in the past. Historically the technology sector has been the best-performing sector in a rising interest rate environment, and the utility sector has been the worst-performing sector.

Essentially, the growth parts of the stock market tend to perform better in a rising interest rate environment, while the more defensive names tend to come under pressure. Another way of thinking about this is that the more the stock is valued based on a known income stream as opposed to earnings growth into the future, the worse the stock performs in a rising interest rate environment.

Just as bonds dramatically underperform stocks in a rising interest rate environment, the more bond-like a stock is the worse it performs in a rising interest rate environment. If interest rates continue their upward trend, I would expect utilities, REITs, and telecom companies to come under some pressure. I am more comfortable owning consumer staples companies if you are searching for yield in a rising interest rate environment.

Additionally, stocks that tend to have relatively less debt on their balance sheet will generate better returns in a rising interest rate environment. The reason is that higher rates means higher interest payments on debt, which puts downward pressure on earnings. This is the opposite trend we have seen since 2009 when stocks with high levels of debt have generally out-performed stocks with low levels of debt, as rates have fallen and stayed low for a longer time than most investors were expecting, causing the earnings of companies with high debt levels to beat analyst earnings expectations. This is the main reason why low-quality stocks have been on a tear over the past few years.

Effectively, the market is at a tipping point, and the rotation towards technology and away from companies with high debt levels should continue to occur. As rates continue to trend higher, we should see defensive, large-cap, debt-intensive, companies come under pressure, and companies that have less debt and greater earnings prospects continue to perform. There should be a rotation out of value and into growth. This rotation was interrupted a bit in April as interest rates trended lower, but the upward pressure on interest rates will resume, and my guess is that growth companies which tend to have low debt levels on their balance sheet will outperform value companies which tend to have high debt levels over the next few years.

Since the expansion is stronger in the U.S. than overseas, due to the intervention of the Federal Reserve, large-cap, multi-nationals should continue to under-perform smaller capitalization companies where the majority of the earnings come domestically.

Putting it All Together

So what is an investor to do? I would recommend following earnings estimate revisions. If the macro thesis is that higher than expected interest rates will cause companies with high debt levels to underperform because interest expense will go up, this will first show up in the earnings estimates of these companies. If an investor is constantly moving towards companies with rising earnings estimates, then you will be moving towards those companies that analysts see benefiting from the changing macro-economic environment. While you will not be early to the party, you likely will not be too late.

Generally speaking, as a portfolio manager, I do not like to react to what I perceive as changes to the macro-economic environment. As has been the case historically, quantitative and unbiased statistical models focused on earnings estimate revisions will tend to outperform intuitive trades based on a reading of the macro-economic tea leaves.