What will happen to interest rates? It is a question many investors are asking and investment professionals are debating.
Since the financial crisis, the Federal Reserve (Fed) has undertaken extraordinary measures to avert deflation and stimulate growth. Signs of economic repair apparent in the housing sector and employment data have reignited investor concerns about higher interest rates. Despite the Federal Open Market Committee’s (FOMC) recent statement that it would continue the current quantitative easing program, Fed Chairman Ben Bernanke’s comments on June 19 unnerved the global capital markets. He said that the program could be scaled back at the end of 2013 and ended in 2014 if the economy continues its moderate growth pattern.
Our presidents, chief investment officers, and other leaders within Fidelity's investment divisions, debated the outlook for interest rates and discussed the implications on June 17. It turned out to be two days before Chairman Bernanke’s comments triggered stock and bond market volatility, even though there were no changes in monetary policy. Our investment leaders' insights are helpful for investors because as the year progresses and new economic data is reported, investor interpretation of implications for central bank policy may well feed continued market skittishness.*
Our Fidelity Investments Roundtable was moderated by Jacques Perold, president of Fidelity Management & Research Co.
Jacques Perold (Moderator): Julian and Dirk, would the two of you put aside your personal biases regarding the likely path for interest rates over the ensuing 18 to 24 months, and provide some perspective on the outlook for rates? Julian, let us start with you. What factors support a case for why rates would continue to rise?
Fidelity Investments Roundtable participants:
President, Fidelity Asset Management
Chief Investment Officer, Pyramis Global Advisors
Chief Investment Officer, Equities
Chief Investment Officer, Equities
Managing Director of Research, and Chief Investment Officer, Global Asset Allocation
Chief Investment Officer, Global Fixed Income
Group Chief Investment Officer, Equities and High Yield
Group Chief Investment Officer, Equities
Head of Global Portfolio Management, Pyramis Global Advisors
Head of Global Portfolio Management, Pyramis Global Advisors
Chief Investment Officer, Money Markets
Head of Research, Global Asset Allocation
President, Fixed Income and Vice Chairman, Pyramis Global Advisors
President, Fidelity Management & Research Co.
Executive Vice President, Investment Business Development
President, Money Markets
Chief Investment Officer, Equities
CIO, Private Wealth Management
Chief Investment Officer, Bonds
President, Global Asset Allocation, and Vice Chairman, Pyramis Global Advisors
Guest participants in this Fidelity Investments Roundtable included Julian Potenza, a macro/asset allocation analyst in Fixed Income, and Dirk Hofschire, SVP, Asset Allocation Research.
Julian Potenza (Fixed Income): Several reasons why rates will likely continue to rise come to mind: First, bond yields are below the rate of GDP growth; second, high fixed income valuations will constrain future returns; third, the pattern of large flows into the asset class is unlikely to persist; and, fourth, several macro risk factors have the potential to weigh on the fixed income sector.
For the sake of argument, assume a “rise in rates” would have the 3-month Treasury bill yielding 50 basis points (bps) and the 10-year Treasury yielding 3.5% at the end of 2014. In my opinion, the trend of nominal growth is a decent barometer of where the 10-year bond yield should trade through the cycle. In early June, the 10-year Treasury was trading around 2%, whereas the U.S. economy has been growing around 4% nominally since the crisis. When interest rates are below the economic growth rate, the bond market is either pricing in a crisis or responding to exceptionally accommodative monetary policy. In fact, both conditions exist today, despite evidence the world and the economy are normalizing.
A combination of improving economic factors and reduced near-term risks supports the case for a reduction in the pace of Fed stimulus. If the Fed continues to see evidence that downside risks are receding, and that the economy can withstand less accommodation, the central bank has said it will reduce the pace of its bond purchases, which would have an impact on the long end of the yield curve and set in motion increases in the 10-year Treasury yield. Expensive valuations in the fixed income market, and broad retail exposure to the asset class, could result in selling and further upward pressure on rates. In contrast to recent fixed income returns, bond yields at generational lows mean prospective returns will likely be limited to the coupon, at best.
There also is a macro angle to consider. To support growth, the Fed wants to deliver negative real returns to bond holders, motivating them to move out on the risk spectrum. China, a major investor in Treasury bonds, could be forced to liquidate its holdings to stabilize its financial system. Central bank balance sheets are larger than ever. Whether these conditions continue or reverse, they remain a source of uncertainty for fixed income assets.
In summary, the fixed income landscape is challenging. Bond prices reflect crisis-like economic conditions despite signs of normalization. Valuations are historically high and investor return expectations may be unrealistic, implying dramatic inflows are unlikely to continue. Finally, the global macro backdrop presents a number of risks. These factors suggest rates will continue to rise over the next 12 to 18 months.
Perold: Dirk, from your perspective, why could interest rates remain low?
Dirk Hofschire (Asset Allocation Research): Let me start by saying that my colleagues and I on the Asset Allocation Research Team (AART) do not believe rates will decline, but while they may rise, there does not seem to be enough evidence to think the 10-year Treasury yield is going above 3.5% any time soon. So long as economic repair continues to be gradual, the Fed will not be in a hurry to tighten. Global growth is still weak, and the interest-rate-sensitive U.S. economy and global low-yield environment could limit rate upside. Lastly, projections for declining working age populations globally imply slower 20-year global gross domestic product (GDP) growth and, as a result, long-term bond yields that may remain below historical averages.
Chairman Bernanke recently reiterated that changes in the scale of the Fed’s quantitative easing purchases and their continuation are dependent on signs of economic growth. Based on the central bank’s response to the extraordinary economic environment since the financial crisis, we can assume it will not change its current monetary policy until unemployment drops below 6.5%, and that the bank will let inflation rise 50 basis points beyond the bank’s 2% target if unemployment remains high. We are nowhere near those thresholds today and current economic trends point to a pace of repair that is likely to be very gradual.
Wages are a significant inflation indicator. The economy is starting from such low levels of wage growth that our inflation model projects little upward pressure on wages until late 2014—and then only at a modest rate. We expect improvements in the economy to continue and the mid-cycle expansion to go on. However, over the course of the next year, the implied growth will fall short of pushing inflation up significantly from today’s level.
Overall, we have a reasonably positive global outlook for 2013—not a robust turnaround, but incremental improvements and a very slow pace of repair. Commodity prices have been in a trading range for the past several years. In certain areas, supply has caught up to demand and the world has recognized a slow growth environment in some emerging markets, including China. It is hard to envision the global economy becoming inflationary during the next 18 months.
The U.S. economy is debt laden, from both a household and government perspective. Positively speaking, debt service ratios for both groups have fallen dramatically. However, this downward trend is dependent on the prevailing low interest rates, making the economy extremely sensitive to a rise in rates. Additionally, the global backdrop of low yields, which also reflect the accommodative monetary policies in effect around the world, could draw foreign investors into the U.S. debt market if U.S. rates rise.
Going forward, U.S. and global demographic trends will likely result in lower average interest rate levels than during the past 50 years. Compared with the past few decades, most countries will derive a much lower contribution to economic growth from rising populations over the next 20 years, and some developed countries will see outright population contractions. Older populations tend to be less inflationary, and slower economic growth has historically been accompanied by lower bond yields.
The formal view of the AART is that eventually we will go back to higher long-term yields. However, they will normalize to a lower level than we’ve been accustomed to during recent history.
Perold: Bob, do you see the yield curve flattening a bit?
Bob Litterst (Money Markets): There is a low likelihood of higher short-term rates until the Fed changes its policy. The Fed has made its exit strategy fairly clear to the market, although the timing of the exit remains uncertain. Sequentially, they plan to change forward guidance and initiate temporary reserve draining operations before actually increasing short-term rates. These actions will boost money market rates at the margin, but a meaningful move higher in short-term rates and a flattening of the curve will require an actual rate hike. The consensus is that the first rate hike will be in 2015.
With regard to interest rates in the bond market, expectations are critical. Chairman Bernanke emphasized that we will see the Fed begin to pull back its bond-buying program in a way that is gradual and contingent on economic strength. This statement alone produced market volatility because the Fed’s asset purchase program has been so significant in the market. Any shift in its behavior could have a meaningful impact on market sentiment and the supply/demand balance.
Chairman Bernanke has been very transparent during his tenure, and appears to be committed to the predictable behavior that characterized the 2004 to 2006 tightening cycle. During that period, despite large cumulative increases in short-term rates, long-term rates remained relatively stable. This was in stark contrast to the Fed moves in 1994, which surprised the market and created a great deal of volatility. I think he favors the 2004/2006 approach and is showing us that Fed actions will likely be transparent and predictable, which he hopes will mute rising rates in the longer end of the curve.
Perold: Would you agree, Tim, that in their protracted search for yield, investors have been seeking bond proxies in the equity market?
Tim Cohen (Equities): Yes. While utilities have historically played that role in the equity market, the environment of managed rates during the past few years has resulted in investors broadening their search for income sources and turning to stocks in the staples, health care, and telecom sectors even more than during the past 20 years. With the recent increase in rates, these sectors have come under pressure. All investments carry some risk.
Perold: When rates have risen, how has the broader equity market behaved?
Cohen (Equities): In general, the S&P 500® Index has done well during periods of rising rates. An exception was the 1994 Fed Funds rate hike cycle, which caught the market by surprise and led the stock market down on fears that the interest rate hikes would slow the economy. Narrowing in on sectors, historically, the financial sector has had strong performance during rising rate periods. Looking forward, you could arguably experience a steeper yield curve for a year before short-term rates rise, which would be an attractive backdrop for financial stocks.
Perold: Is history a reasonable guide this time for financials, which have had such a good run after being decimated in 2008?
Joe DeSantis (Equities): Generally, our equity portfolio managers focus first on valuations rather than trying to predict interest rates. Concerning the U.S. financials sector, we have seen a number of the large-cap core portfolio managers move to an overweighting in financials, most notably in our growth and income portfolios. In some other portfolios, relatively small exposure to real estate investment trusts (REITs)—in some instances, virtually no exposure—has contributed to an underweighting in the financial sector. This positioning has offset the portfolios’ active weightings in large money center banks, asset managers, and some investment banking stocks. Future increases in the financial sector weightings will likely rest on whether managers decide to buy insurers. While these companies tend to be highly sensitive to interest rate moves, increased rates can better position them to match long-term liabilities and improve their business margins on newly written annuity business.
Brian Enyeart (Global Asset Allocation): Internationally, we were substantially underweight financials across our strategies. Unlike the United States, where collateral has improved, in Western Europe there is still substantial sovereign exposure on the asset side of the balance sheet and regulatory uncertainty continues to be a factor.
Pam Holding (Pyramis Global Advisors): We are spending some of our risk budget in the financial sector in asset managers, large banks, and large money center banks—not as much in insurers.
Perold: What about other sector exposures, especially the consumer sector that has outperformed the general market for quite some time?
Holding (Pyramis Global Advisors): We think that interest rates moving higher reflect an economy that is in a more constructive state. In the large-cap portfolios we were positioned for a cyclical recovery—overweighted in consumer discretionary, financials, and technology—and this overweighting contributed positively to performance in the second quarter.
Bran Hogan (Equities): In terms of sectors, many of our growth portfolios were not positioned for industrials to outperform technology. We thought valuations for technology companies were more attractive than those for industrial companies. While these portfolios did participate in the gains from the strong performance of the housing sector, they did not do so in the context of the broader industrial sector.
Perold: How would you characterize the multiple expansion in the marketplace?
Hogan (Equities): The price/earnings ratio (P/E) for the market—the multiple—has been steadily declining since the end of 1999 due to a number of macro factors. However, over that time period, earnings have more than doubled. During the past few years, I have observed the stock market evolve from double-digit earnings growth with no multiple expansion to a combination of earnings growth and multiple expansion. The S&P 500® Index is now trading at 14 times next year’s earnings. Interestingly, some of the slowest growing stocks have the highest valuations because of their dividend yields, which is a testament to the demand for income investments.
Tom Hense (High Yield and Equities): ...and the demand for highly consistent earnings.
Perold: How are the portfolio managers who are making asset allocation decisions viewing the market?
Bruce Herring (Global Asset Allocation): For those making tactical decisions, most out-of-benchmark moves are within fixed income in terms of credit and quality.
At this stage of the cycle, investors tend to stretch for yield, so we are seeing some portfolio managers move allocations closer in line with the benchmark. As credit starts to widen, it will be interesting to see which fixed income managers in the market had too much risk. I often discuss these types of issues with Christine.
Christine Thompson (Bonds): Yes, it will be interesting. During a rising rate environment, there are typically two phases. When rates initially rise, spread securities usually outperform because credit quality helps to buffer the portfolio. However, when portfolio liquidity gets drawn down and managers have to sell and thereby test bids in the market, investors can see a dramatic repricing of credit spreads. To date, we have seen a little lower-quality selling.
Perold: What does this mean for high yield?
Hense (High Yield and Equities): High yield is well situated in an economy that is strengthening, albeit slowly, with low default risk. When considered alongside its average duration of four years, the asset class can look compelling. To Christine’s point, if rates move consistently higher resulting in high yield issuers facing higher refinancing rates and/or if market liquidity dries up, the outlook could be less favorable.
Derek Young (Global Asset Allocation): In the asset allocation space, high yield can be a significant alpha opportunity. We have been able to benefit from this asset class because of the careful research conducted in Tom’s group.
Perold: Dirk, as Bob Litterst shared, Chairman Bernanke has been transparent about the possibility of the central bank tapering monthly bond buying at the end of 2013. What effect will this have on market volatility and how should it influence investors’ asset allocation decisions—if at all?
Hofschire (Asset Allocation Research): If the economy is getting traction and that is the reason interest rates start to go up, then stocks can probably do fine in that environment. Stocks actually have a history of doing fairly well even when rates are rising. This can be a more difficult environment for bonds, but, again, the timing and magnitude of those rate increases are going to be very important. Maintaining a diversified portfolio, with a mix of equities and fixed income investments, in an environment where the economy is getting better is a reasonable course for investors.