Bond yields have been moving higher for the past month as fixed income traders are taking more seriously the notion that the Fed may raise rates starting in December. There is also a growing chorus of Fed officials talking of two more hikes in 2017 followed by two more in 2018. Even if there are five quarter-point rate increases that fit this dot-plot plan, the Fed Funds Rate will be at 2.0%. Investors have gotten very comfortable with super-low interest rates and, to a large extent, global equity markets have as well.
With that said, the old saying of “don’t fight the Fed” is being heard again, and with the S&P 500 trading near its all-time high, there is an elevated level of chatter as to how high the market can trade in a rising-rate environment. In all actuality, it might be surprising to hear that historically, equity prices have often rallied in both the run-up to policy rate-hike cycles and in the year following the onset of rate increases. The health of the economy is a key consideration.
While there is no perfect historical precedent for the Fed’s extraordinary post-crisis monetary policy that has added $3.6 trillion to the Fed’s balance sheet, there is a precedent of equity market performance amid rising interest rates. Equities have advanced in the majority of periods when the broader economy was expanding and higher rates simply reflect the rising pace of economic activity. Economic expansion has historically been an underpinning of corporate earnings growth, which historically has often been identified as a driver of long-term stock returns.
In the immediate wake of change in monetary policy, markets can most certainly endure bouts of volatility and rapid sector rotation, as has been the case for the past month. Fund flows out of telcos, utilities and consumer staples have been very pronounced, whereas fund flows into financials, information technology, energy, consumer discretionary equities and natural resources have been quite bullish. The repositioning of capital during September and October is to be taken seriously, because whether the Fed does actually raise rates in December takes a backseat to investor perception that they will in fact move. Perception has always trumped reality in how markets trade, and this natural law of the stock market is at work once again.
For income investors, taking the sector rotation at face value, the hunt for yield should be directed at energy infrastructure (i.e. pipeline) master limited partnerships (MLPs), closed-end covered-call funds that have high exposure to information technology, energy and natural resource stocks, floating rate senior loan lending companies (BDCs) and commercial finance real estate investment trusts (REITs) with adjustable rate sources of revenue. Rebalancing portfolios for income in a rising-rate market doesn’t mean wholesale jettisoning of one’s AT&T (T) or Southern Company (SO) shares, as these stalwarts will still grow earnings and dividends, but they may underperform in the short term.
Taking appropriate action to adjust for a different investing landscape is prudent, especially if one’s portfolio is heavily skewed towards long-term bonds and other fixed-income investments like preferred stocks, closed-end bond funds that use leverage to generate yield and other long-dated assets like Ginnie Maes or corporate bonds. These classes of securities stand to be at serious risk of principal erosion once the Fed embarks on a tighter monetary policy and, as such, should be considered for reducing the size of positions or swapping for shorter-term maturities and settling for less yield.
It pays to be proactive, because markets tend to over-react to the upside and especially to the downside. At Cash Machine, we take a dynamic approach to the changing investment landscape, being sensitive to these shifts in policy and sentiment by reducing exposure to fixed-rate assets and moving more into rate-sensitive assets. Having some cash on the sidelines during a transition in interest rate policy can also reduce risk while affording opportunities in short-term bouts of market selling pressure.
Fear is so much greater than greed, and when many rate-sensitive high-yield assets get thrown out with the fixed-income bathwater, it really pays to have some dry powder that can be put to work in heavily discounted assets. Having a well-seasoned high-yield income advisory service to guide where capital dedicated for income can be invested in an up-rate market can also be a valuable asset in one’s investing toolkit. Click here to learn what makes Cash Machine so useful to investors.
In case you missed it, I encourage you to read my e-letter column from last week about why the tech sector is the place to be right now.