Fidelity senior investment leaders recently met to discuss the global interest rate backdrop, the outlook for rate policy in 2017, and the asset allocation implications of rising rates. This paper summarizes the key highlights of that discussion.
Interest rates: Higher, but still historically low
For the past three decades, interest rates in the U.S. have steadily declined. Many secular forces have contributed to their fall, including aging demographics and the move from high to low inflation rates. Rising globalization has contributed to the disinflationary environment, as global supply chains, the free-flow of trade across borders, and the ability to access labor around the world have driven down the cost of goods. Technology also has helped to suppress inflation. In recent years, the secular forces that pushed down bond yields were amplified by cyclical factors, including weak global growth, plunging commodity prices, and extreme central-bank policies, including quantitative easing and negative interest rates.
In the first half of 2016, stretching from the market turmoil in January to the Brexit vote in June, assets appeared to be pricing in a worst-case scenario. Widespread pessimism about growth, extremely low inflation expectations, extraordinary easing stances from central banks around the world, and strong demand for U.S. government bonds drove Treasury yields to all-time lows.
However, the underlying trends of the global economy and inflation were already accelerating. China’s economy, a focal point of global volatility, began to improve. The trade and industrial recessions of late 2015 were on the wane, industrial production was recovering, commodity prices were climbing, and U.S. wages were accelerating as labor markets tightened. Starting around mid-year, a turnaround began to take hold as markets recognized these developments. S&P 500® earnings also rose about 3% in Q3 after six consecutive quarterly declines. These signals of economic improvements, along with indications of rising inflation pressures and a shift in Treasury supply/demand dynamics (see chart, below), drove rates higher.
Signs that the U.S. economy is nearing full employment, combined with higher inflation and an improving global macroeconomic backdrop, gave the Fed the ammunition it needed to implement a 0.25% increase in the federal funds rate, to a range of 0.50% to 0.75%. The Fed also reported it expected to raise rates three times in 2017.
Rate hike forecast for 2017
The strength of the U.S. economy and inflation will likely dictate where rates go from here. Inflationary pressures, including higher wage growth, continue to build. And with a new president about to take office, it is difficult to predict how future policy decisions may influence the economy, especially with some disparity between Trump’s priorities and those of the GOP Congress. It seems reasonable that some aspects of the growth agenda are likely to be implemented and could boost cyclical growth during 2017. However, it is also possible the impact might be partially offset by a greater-than-expected protectionist tone in the policy mix.
Amid that context, here are two likely scenarios for the U.S. economy and interest rates in 2017:
- U.S. growth accelerates materially in 2017, presumably boosted by fiscal stimulus and pro-business policies, causing the economy to overheat. This faster-growth scenario would likely be accompanied by higher inflation, a pick-up in global growth, higher commodity prices, and a Fed that hikes rates but stays patient, and is generally perceived as behind the curve.
- U.S. growth is stable but does not meaningfully accelerate, presumably because policies are not as effective or growth-oriented as hoped, which leaves the economy rolling slowly toward late cycle. This pattern might feel similar to much of what occurred in 2016. The Fed may still hike patiently but would be perceived as being even with or ahead of the curve.
Over time, government bond yields (such as the 10-year Treasury) generally should correlate with the long-term rate of economic growth. On a secular basis, if rates are driven by growth and inflation, they should be around 3.5% to 4%. Fidelity's Asset Allocation Research Team's (AART's) current forecast for nominal GDP growth is 3.6%. However, the 10-year Treasury is yielding only 2.5% as of early January, even though it has risen considerably since mid-2016. Therefore, the authors of this paper forecast that in 2017 rates will remain low relative to their history, but they should trend higher than they are today. Rates would need to increase by another 100 basis points or so to reach AART's long-term GDP estimates. While by no means certain, it is possible that the secular era of rising globalization, falling inflation, and declining bond yields may be losing steam, and possibly may even be nearing an end.
Inflation outlook for 2017
Though the new administration increases the uncertainty around the outlook, higher oil prices and continued wage growth are primed to generate a more meaningful rise in inflation. During the past year, headline CPI has accelerated from 0.0% to 1.5% year-over-year, while core inflation (which excludes food and energy) has risen from 1.9% to 2.2%. The Treasury market’s long-term inflation expectations, as implied by the TIPS market, have begun to drift higher, although they remain subdued relative to history and the Fed’s inflation target. With core inflation firm and oil prices poised to rise above early-2016 trough levels, headline inflation could approach 3% by the end of the first quarter of 2017.
Asset allocation implications of rising rates
Investors should start with a portfolio design based on their individual financial situation, risk tolerance, goals, and timeline. For many investors with a solid plan, it may make sense to stick with that plan regardless of the rate environment. But within a diversified investment mix, it may be worth understanding the different ways rising rates affect different types of investments. Here are some asset allocation implications investors may wish to consider.
Most investors are aware that bond prices fall as rates rise. But higher rates do not always coincide with negative returns. There are a number of bond sectors and strategies that investors can use to their advantage when interest rates are rising. Consider the following:
Short duration: Amid historically low bond rates, investors who sought higher yields in longer-maturity debt may have overexposed their portfolios to interest rate risk. Short-duration investments can help mitigate that risk. When short-term rates rise, short-duration investments can generate positive returns due to their relatively consistent interest income, and offer the ability to reinvest in comparatively shorter periods.
High-yield bonds: Relative to investment-grade government debt, bonds with higher yields—such as high-income corporates—have historically tended to be less sensitive to rising interest rates because the higher income these bonds earn to compensate for greater default risk may offset the price declines from higher rates.
Foreign government debt: Investing in developed-market investment-grade debt outside the U.S. has historically helped diversify a bond portfolio and provided a hedge against rising rates at home. Of course, foreign-exchange rates are an important consideration, because a change in the value of a country’s currency relative to the dollar can undermine the performance of non-U.S. debt.
TIPS (Treasury Inflation-Protected Securities): TIPS have outperformed Treasuries of late, partly because many of the Trump administration’s policies are expected to be inflationary (e.g., corporate tax reforms, more-restrictive trade policies). While TIPS may provide value as part of an overall diversified portfolio, valuations relative to Treasuries have recovered from their post-financial-crisis lows in February 2016 and are now approaching their long-term average, which may provide some reason for caution.
Floating-rate bonds: Unlike fixed-rate bonds, the interest on floating-rate debt adjusts regularly to stay on pace with short-term interest rates. Like other corporate bonds, these bonds come with the risk that the issuer will fail to make payments. But, if rates continue to rise, floating-rate bonds could do well.
Leveraged loans: Unlike traditional bond funds, which typically suffer when interest rates rise, leveraged-loan funds invest in debt whose coupons adjust with interest rates, offering investors a stable and attractive income stream in a rising-rate environment. Leveraged loans can also offer investors more downside protection relative to high-yield bonds given their senior position in a company's capital structure.
MBS (mortgage-backed securities): High-quality MBS can be an alternative to Treasuries and can offer an opportunity to pick up some incremental yield. However, MBS generally underperform Treasuries when interest rate volatility rises. It will be important to monitor the relative pricing of mortgage securities to be sure to be adequately compensated for higher market volatility.
- Read Viewpoints: Bonds 2017: a new dynamic
The broad stock market has historically been modestly positive in the year following a rate-hike cycle, with income-related equities demonstrating the most vulnerability. Here’s a closer look at how various equity categories have responded to a rising-rate environment.
Equity sectors: During the past half-century, energy, technology, and health care have been the best-performing sectors, on average, relative to the market when rates are on the rise (see chart), while consumer discretionary and utilities have done the worst. Though its historical performance has been mixed when rates rise, our experts think that the financials sector could do well in this rate cycle. Credit has an overwhelming effect on the critical factor of relative earnings growth. In a profit recovery as strong as this one could be—given potential tax and regulatory changes—there is strong potential for improved credit, which could boost financials relative performance.
However, the sector performance story can change depending on whether rate hikes come in a growing economy, or during an economic slowdown. In a growing economy, cyclical sectors have significantly outperformed, most notably technology. Conversely, in a slowing economy, defensive sectors provided better average performance, led by health care.
- Read Viewpoints: Sector impact of rate hikes
Dividend-paying stocks: Rising bond yields and the increased prospects for higher policy rates have caused sectors with the highest dividend yields to suffer lately, as bond yields have become relatively more attractive. Although income-producing equities in the aggregate have held up, the tailwind of a low and declining rate backdrop is likely to become a headwind going forward. However, dividend-yielding stocks are a heterogeneous group, and lower-payout, faster-growing dividend payers have historically held up well in rising-rate environments. Over the long term, dividend-paying stocks have offered compelling returns relative to non-dividend-paying stocks, and have done so with lower volatility.
- Read Viewpoints: New era for dividend stocks.
Real return assets
Real return is a multi-asset-class strategy that seeks real (inflation-adjusted) return by investing in a diversified mix of securities with inflation-fighting potential. Real return assets include floating-rate debt, real estate-related investments, commodities, and inflation-protected securities. Inflation, even at 2%, can be insidious to the returns of a portfolio. Real return assets have historically provided a hedge against inflation, have generally performed well in rising rate environments, and have had a very low historical correlation to stocks and bonds.
In closing, 2017 may be a year well-suited for active management
The current environment of policy uncertainty has prompted many industry observers to suggest that there will be more opportunity for active management in 2017—in both the equity and bond markets—than there has been in recent years. The correlation between and within asset classes has trended lower recently, meaning return dispersion has increased. This can give active managers an opportunity to identify investments with higher potential returns. Regardless of what 2017 brings to the stock and bond markets, it looks like change is coming. But that doesn't mean your investment strategy needs to change. The first priority should be to determine an appropriate long-term asset allocation between stocks, bonds, and cash—and stick with it.
Joanna Bewick | Portfolio Manager, Global Asset Allocation; Denise Chisholm | Sector Strategist, Equity; Tim Cohen | Head of Global Equity Research Joseph DeSantis | Chief Investment Officer, Equities; Brian Enyeart | Chief Investment Officer, Strategic Advisers, Inc.; Bruce Herring | President, Strategic Advisers, Inc.; Tom Hense l Group Chief Investment Officer, High Yield and Equities; Dirk Hofschire l Senior Vice President, Asset Allocation Research; Brian Hogan l President, Equity Group; Pam Holding | Chief Investment Officer, Fidelity Institutional Asset ManagementSM; Tim Huyck | Chief Investment Officer, Money Markets; Bill Irving | Portfolio Manager, Investment-Grade Bonds; Nancy Prior | President, Fixed Income; Angelo Manioudakis | Chief Investment Officer, Global Asset Allocation; Darby Nielson | Managing Director of Research, Equity and High Income; Julian Potenza | Research Analyst, Fixed Income; Naveed Rahman | Institutional Portfolio Manager, Equity Income; Melissa Reilly | Chief Investment Officer, Equities; Christine Thompson | Chief Investment Officer, Bonds; Derek Young | President, Global Asset Allocation.
The S&P 500® Index is a market capitalization–weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance. S&P 500 is a registered service mark of Standard & Poor’s Financial Services LLC.
Exhibit 3 reflects average returns for periods when the federal funds rate was rising, from Jan. 1962 to Sep 2016. Sector returns based on a proprietary Fidelity database of stock returns. Stocks sorted into sectors using the GICS® classification for the universe of the 3,000 largest U.S. stocks. The index was market-capitalization weighted and reconstituted monthly. Rising rate periods start in the month when the year-over-year (yoy) fed funds rate rises and ends when the yoy funds rate falls. Average relative performance shows simple average of cumulative returns during each rising rate period, relative to the overall universe of 3,000 stocks. Defense is a simple average of the average relative performance for consumer staples, utilities, health care, and telecom during all periods of rising rates. All other sectors were considered cyclical. Source: OECD and Fidelity Investments, as of Sep 30, 2016.
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