By: Deron McCoy, Chief Investment Officer, CFA®, CFP®, CAIA, AIF®
Sam Miller, Senior Investment Strategist, CFA®, CAIA®
Back in March 2017, after the Federal Reserve lifted the range of the Federal Funds rate to 0.75% (technically a 25 basis point range of 0.75% to 1.0% but we like to quote the lower bound), we stated in the New York Times, “The first four to eight rate hikes are the low-hanging fruit,’ said Deron McCoy, the chief investment officer at SEIA, a Los Angeles firm. ‘The real test will be whether the economy can withstand positive real rates. And that still seems to be a 2019 topic.”
Well here we are! The Federal Reserve announced a 0.25% increase in the Fed Funds rate this week and the big topic of conversation is indeed whether the economy will be able to withstand positive real rates (i.e., the nominal rate less inflation). With the Fed’s latest move bringing nominal rates to a range of 2.25%-2.50% and inflation running near 2.0% (Source: BLS), the real rate today is now positive for the first time in years. And unfortunately, the economy is already starting to wobble—at least the parts of the economy that are interest rate sensitive such as housing. Any future hike will push real rates further into positive territory and potentially further dampen economic activity, perhaps even tipping us into recession.
In our opinion, the fed should use monetary policy in the form of rate increases to remove excesses from the economy (euphoria) and to thwart inflation. But with softening home prices and equities off 10-20% we are simply not in a ‘euphoric’ environment. And now with crude oil back down below $50 a barrel (Source: Bloomberg), out of control inflation appears to be nowhere on the horizon. Considering the economic unknowns from ongoing tariff/trade negotiations, we simply aren’t in an environment that demands higher interest rates.
So, what to do now that the low hanging fruit is gone? In our opinion, for the Fed, Jerome Powell and his team should have awakened to this new economic reality and pivoted away from their 1.0-1.5% real rate forecast (equaling another 4-6 hikes). While they ratcheted down 2019 expectations to 2 hikes, the market still responded disapprovingly, at least in the short-term. The good news is that there’s a precedent—in early 2016, the Fed awoke to a changing economic landscape (and materially lower crude oil prices) and paused their rate hike cycle. Recession was seemingly taken off the table and capital markets reacted positively. Similarly, we are of the opinion that income investors need to pivot here as well. During the most recent periods of rising interest rates (after the days of zero interest rate policy (ZIRP) and following Brexit when the yield on the 10-year Treasury Bond fell below 1.40%) ‘unfixed income’ and floating coupons were the mantra of the day. Now, however, as we approach the end of the interest rate cycle, the days of ‘unfixed income’ may be ending. Watch the Fed but be ready to increase your fixed vs. floating coupon exposure as we move through 2019.
And for equity investors?
Many non-economic factors are pointing to a profitable 2019 namely that next year will be the 3rd year of the presidential cycle—a year which historically has awarded investors with outsized returns (Source: Strategas). But this presidential cycle does seem a bit different, so perhaps we should focus on taking our cues from the Fed.
If the Fed does pivot, keep in mind we haven’t had a recession (dating back to 1960) when the real fed funds rate is less than 2%. Without a recession, we would expect earnings to continue to march higher albeit at a slower clip than in 2018 (which saw double digit growth driven in large part by the tax cut). Mid-single digit EPS growth seems doable, but the really good news is that in a more certain environment (Fed pause, trade deal, etc.) valuation multiples could expand, providing a nice double tailwind to equities. Many strategists see the S&P 500® potentially reaching 3000 in twelve months—a near 20% total return including dividends (Source: Barron’s)
Happy Holidays indeed!!
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