The FED Getting It Right Would Be Scary For Stocks

December 19, 2016

The FED Getting It Right Would Be Scary For Stocks

  • A negative scenario implies economic growth and inflation not reaching the FED’s estimations, which wouldn’t be such a bad thing for stocks in 2017.
  • A positive scenario implies the FED’s estimations to be met, a potentially dangerous situation for stocks.
  • A federal funds rate of 2.1% by the end of 2018 would see the S&P 500 at 1,629 points, all other things being equal.

Finally, The FED Had The Courage To Increase Rates

After more than a year of waiting, the FED finally decided to increase interest rates.

You probably know that this is because unemployment has reached natural levels and inflation is rapidly moving towards targeted levels. On top of that, the FED forecasts to raise interest rates by another 0.75 percentage points in 2017.

Today we’ll discuss the potential repercussions this rise in rates could have on the economy and our portfolios.

Repercussions On The Economy

Raising interest rates was largely overdue, so the FED had to budge. However, this will be a very interesting experiment as never before in history we have had such a long period of near zero interest rates.

Figure 1: Historic interest rates. Source: FRED.

Nobody knows what repercussions this will have on the economy. We’ll elaborate on a few scenarios.

The negative scenario is that higher interest rates hit the brakes too hard and push the economy into a recession or slow it down. The FED’s projections seem very linear and if we know something for a fact, it’s that nobody can predict economic developments for the next few years and these developments aren’t going to be linear for sure.

Figure 2: FED’s economic projections. Source: The Federal Reserve.

For the next few years, the FED forecasts stable economic growth just below 2%, stable unemployment between 4.5% and 5%, inflation at 2%, and the federal funds rate going up to around 3% by 2019.

The main theory behind the negative scenario is that the economic growth achieved in the last few years was mostly because of low interest rates. Low interest rates enable you to borrow more, more investment projects are profitable as the required return rate is lower and debt costs are much lower. This was also the purpose of the near zero interest rates, to pull the economy out of the financial crisis. However, due to the fact that low interest rates lasted so long, we can’t know if the economy is healthy or just on low interest rate steroids.

Figure 3: U.S. GDP annualized growth. Source: Trading Economics.

Further, higher interest rates make the dollar a more attractive currency to stash wealth in pushing the dollar index higher. This makes the U.S. economy less competitive from a global perspective, lowering exports and increasing imports. Just as an example, imagine you wanted to buy a nice luxury sedan, a $70,000 European car in 2014 would currently be priced at around $50,000. This a big discount that makes producers outside the U.S. much more competitive.

As interest rates in Europe are still far from increasing, the strength of the dollar could weigh on economic growth and the FED’s projections. An example is U.S. industrial productivity, industrial capacity use is at 75%, 5 percentage points lower than the historical average, and industrial production has declined 0.6% in 2016.

A situation where GDP growth and inflation don’t meet the FED’s expectations would postpone the three expected rate hikes in 2017 and keep the current status quo on financial markets with low interest rates, thus, investors would stay happy with low earnings and dividend yields.

An extremely negative scenario would be that the above really pushes the U.S. into a recession and lowers corporate earnings. This is a bit extreme as the FED would quickly intervene by lowering interest rates or increasing liquidity.

Repercussions On Stocks If The FED Gets It Right

For stocks, the FED getting in right is far more dangerous than the FED getting it wrong.

A federal funds rate of 1.4% in 2017 with expectations of it going to 2.1% in 2018 and 2.9% in 2019 would increase all interest rates proportionally. In the last few decades, treasury yields and junk bond yields have fallen alongside lower interest rates.

Figure 4: Federal funds rate and interest rates. Source: FRED.

With higher interest rates, the trend would reverse pushing required returns higher, and bringing down stock valuations. As higher interest rates would increase borrowing costs for corporations, it would probably cancel the benefits economic growth and inflation would bring to earnings sending stock prices heading south.

Figure 5: S&P 500 PE ratio. Source: Multpl.

The current earnings yield stocks give us is 3.83%. If we increase that yield by 1.5 percentage points, i.e. by how much the FED expects to increase rates by the end of 2018, we would get to a required yield of 5.33%. All other things being equal, the S&P 500 would then be at 1,629 points, a 28% decline.

In order for the S&P 500 to stay at current levels with interest rates increasing, S&P 500 earnings would have to grow by 40% in the next two years. Something highly unlikely, especially with the strong dollar lowering international revenues and higher interest rates increasing debt costs.

All Stocks, But Especially Yielders, Are In Danger

In a negative scenario, we could see economic growth slowing down, while in a positive scenario, we should see higher required returns from stocks. Such a situation sounds more like a lose-lose situation, but this is the reality we are confronted with. Stocks might follow their own path for a while, but in the end, they will have to surrender to higher yields.

A good option might be to seize the strength of the dollar and look more toward international diversification, and to exchange your yielders like REITs or utilities with stocks that have lower dividend yields but may show higher growth rates in a strong economic environment. Also, don’t forget to look at interest payments and debt refinancing as a higher federals funds rate immediately leads to higher borrowing costs.

By Sven Carlin FED Interest Rates Investiv Daily Share: