Why Rising Rates Won’t Kill the Bull Market

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It has been nearly nine years since the Federal Reserve last raised interest rates, and many investors are uncertain about how inevitable hikes will impact the market. Certainly, accommodative monetary policies have contributed to the current bull market. Businesses have taken advantage of low borrowing rates. In fact, U.S. corporate debt issuance hit an all time high of $1.5 trillion in 2014. Many soothsayers have attempted to predict when the increase will happen, but have been proven wrong.

Fed Chair Janet Yellen has indicated rates will likely rise sometime in 2015, as long as the economy is healthy enough to withstand monetary tightening. Investors are becoming nervous because raising interest rates temper economic growth as borrowing becomes more costly. Viewed in isolation, rising rates do not benefit the stock market. However, the underlying reasons for increasing rates do bode well for the economy and will likely outweigh any negative headwinds from Fed actions. These factors bode particularly well for active managers and small-cap stocks.

U.S. gross domestic product in the third quarter grew at a 5 percent pace, the fastest it has in 11 years. This follows a 4.6 percent growth rate in the second quarter. Consumer spending, which accounts for the bulk of GDP, grew by 3.2 percent, and business investment increased by 8.9 percent. Both point to increasing confidence and reflect an improving job market. Falling energy prices will provide a tailwind for consumers and businesses that are net consumers of energy. This will likely continue to support the growth of the U.S. economy.

The job market is growing at the fastest pace in 15 years. In 2014, the unemployment rate fell to 5.6 percent, as 2.95 million Americans found employment. According to the Job Openings and Labor Turnover Summary, there are currently 5 million job openings in the U.S. This is the highest level since 2001 and will likely remain robust, as increasing levels of business confidence indicate more hiring. Concerns over layoffs in the energy sector appear overblown and will not cause a material disruption to employment growth. The entire U.S. oil and gas extraction industry accounts for less than 0.5 percent of total private sector employment, or about 500,000 jobs, according to the Bureau of Labor Statistics.

Wage growth is likely to accelerate in 2015. A persistent stain on the impressive growth in employment has been stagnant wages. Over the past five years, the average wage has only increased at an annual rate of 0.7 percent. Though explanations abound, normally upward pressure on wages does not materialize until the labor market tightens to the point companies must compete for talent. Historically, that is when unemployment declines below 5.5 percent. We are just on the cusp. As job growth continues to improve in 2015, wages are likely to show signs of improvement.

Economic growth will drive the market higher, but active managers will benefit the most. Since 1958, the Fed has raised rates 14 different times. The average annual return for the Standard & Poor’s 500 index was 9.6 percent during those periods. Active managers on average beat the index by 1.5 percent per year in a rising rate environment, while underperforming by about 2 percent annually when rates are falling. Falling rates encourage investors to pay higher multiples for all stocks, and even unprofitable businesses benefit from the rising tide.

Said another way, this dispersion narrows and the differences between the best and worst performing stocks are minimal. When rates increase, stock reactions are more correlated to their underlying fundamentals and dispersion widens. Selectively picking more profitable businesses, and excluding the unprofitable ones, will help active managers generate alpha as the market becomes more discerning.

Small-cap stocks tend to outperform during rising rate environments. This appears counterintuitive, but illustrates why the market will continue to grow. Investors like small companies because of their high earnings-growth potential. To determine a stock’s worth they estimate the value of those future earnings today. To do this, future earnings are discounted, using prevailing interest rates. So, in theory, a higher interest rate means future earnings are discounted at a higher rate, and thus the value of those earnings today should be less.

A different characteristic of small-cap stocks provides an explanation for the outperformance. Small-cap stocks tend to benefit from a strengthening economy more than large-cap stocks. The rationale is exactly the same as for the entire economy, though it is more pronounced in small caps. The future earnings of small companies will be higher because of the stronger economy, which more than offsets the higher discount rate. Because active managers tend to favor small-cap stocks, this phenomenon could partially explain why they outperform during rising rate environments.

The Fed uses monetary policy to stabilize the economy. When economic growth deteriorates, the Fed loosens monetary policy to reignite growth. A tightening policy is indicative of a healthy economy, and thus a healthy stock market, especially early in the rate-hiking cycle. Typically, it is shortly after the Fed stops increasing rates that the market declines. About a year after they stopped raising rates in 2006, the financial crisis hit. Though the recent sell off in oil and the ongoing struggles in the Euro zone indicate slowing global growth, the U.S. economy is proving resilient and economic indicators point to a robust recovery.

As the unemployment rate continues to fall, wages will begin to rise and consumers will continue to support GDP growth. This should more than offset any headwinds, as the Fed tightens monetary policy. The drivers of equity performance will revert to fundamentals, which will pave the way for active managers to generate alpha. Concerns of slowing growth have not been validated by recent economic data. Fearful investors who shift to conservative strategies in order to reduce volatility will likely miss opportunities in 2015. A better approach would be to selectively focus on individual companies that are continuing to demonstrate robust earnings growth with solid balance sheets.

U.S. News & World Report

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