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What Do Rising Interest Rates Mean For Investors?

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With interest rates inching upward in the U.S. and elsewhere following a period of sustained low rates, what should investors do to maximize their earnings?

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Last month, the Federal Reserve raised interest rates and signaled it will raise interest rates more this year. This followed a raise in December, the first in more than a year.

Interest rates can impact all types of investments, from savings accounts to certificates of deposits, to investment grade equities, to high quality debt, to junk bonds.

Market Reaction Uncertain

When interest rates rise, the price of bonds drops, according to Investopedia. Many analysts predicted that falling bond prices would cause equities to lose value. This, however, has not been the case. Equity values have not suffered on account of the rising interest rates to date.

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But this does not mean the situation won’t change, especially with further rate hikes planned.

The stock market’s strength has been driven by expectations that the Trump administration will increase spending and lower taxes.

But when stock markets react to political and economic events, stock market corrections often follow.

Hence, it’s not hard to see that in the present climate, uncertainties exist for stock values. Investors are advised to consult with professionals on investing and not act on impulse, regardless of their bonds and equities mix.

More Rate Hikes To Come

In December, The Fed voted to raise the federal funds rate by 0.25% to a target 0.5 to 0.75%. Stock prices did not change, giving investors a signal not to change investment strategy.

However, the Federal Open Market Committee, the Fed’s interest rate setting panel, indicated there will be three rate hikes in each of the next three years, marking a faster pace of hikes than it previously indicated.

The target range could be as high as 2.75% to 3.00% by the end of 2019.

Since the range was 0.00% to 0.25% through December 2015, the change could be seen as dramatic.

Impact On Banks

The key policy rate applies to lending between banks out of the reserves they hold at the Fed. It does not impact non-bank borrowing directly, but it does affect it indirectly.

The federal funds rate represents the cost that depository institutions pay for borrowing from Federal Reserve banks. It is the rate the Fed uses to control inflation. By increasing this rate, the Fed shrinks the supply of money available for financial activity by making money more expensive.

The federal funds rate determines the prime lending rate, the rate commercial banks charge their most creditworthy customers. The prime rate is the basis for credit card rates, mortgage rates and other loan rates.

Following the Fed rate change, every major bank said they would raise their prime lending rates from 3.5% to 3.75%.

Savings And Money Market Accounts

Banks also pay depositors higher borrowing costs. Hence, a savings or money market account that only pays a few dollars a year will pay more.

Banks profit from the spread between their lending rates and their borrowing rates, and they have little incentive to pay more on deposits and reduce their profits. But deposit rates are still likely to rise on account of competition among banks.

A small number of banks have recently raised rates for savers, according to Forbes. These increases are not great, but they are moving in the right direction. The best rates are offered by online banks, small banks and credit unions.

Banks have been more willing to raise rates on certificates of deposit, according to depositaccounts.com.

Due to the length of time it takes for banks to raise rates on deposits, they will incur better profits, and their investors will share in these gains. Bank of America’s stock rose 2.9% in a two-day period in December. JPMorgan’s rose 1.9%.

Impact On Corporate Profits And Stocks

The impact of the federal funds rate on the stock market is not direct. But there is an indirect effect.

Since they have to pay more to borrow money, banks increase the rate they charge their customers to borrow money. This results in higher mortgage and credit card rates, particularly those loans carrying variable interest rates. This reduces the amount of money for consumers to spend. When paying bills becomes more costly, there is less disposable income, which impacts companies’ revenues and profits.

Businesses also borrow from banks. When businesses have to pay more for money, they often choose to borrow less money, which in turn slows their growth. This can hurt earnings, causing a decline in stock prices.

If a company cuts back on investing, its estimated future cash flows will decline, which lowers the price of its stock.

Should a large number of companies suffer declining stock prices, the market indexes such as the S&P 500 and Dow Jones Industrial Average decline.

Investors do not get as much stock price appreciation when stock values decline.

Financial Stocks And T-bills

The financial sector, however, often benefits from interest rate hikes. Banks, insurance companies, brokerage houses and mortgage companies often earn more since they can charge more for lending.

Interest rates also impact bond prices and returns for T-bonds, T-bills and certificates of deposit. As interest rates rise, bond prices fall.

The longer the bond’s maturity, the more it fluctuates in relation to the interest rate.

When the federal funds rate rises, new government securities like bonds and T-bills are seen as safe investments and post an increase in interest rates. The “risk free” return rate increases, making such investments more attractive.

When the risk-free rate rises, the return needed for investing in stocks also increases. If the required risk premium falls while the potential return decreases, investors are likely to see stocks as risks and will invest elsewhere.

Impact On Bonds

Businesses and governments often raise funds through bond sales. When interest rates rise, so does the cost of borrowing. The demand for lower-yield bonds falls, bringing their price down with them.

Jeffrey Gundlach, DoubleLine Capital chief investment officer, noted the Fed tightening corresponded to a gain in 10-year Treasury yields. These could reach 4% in the next year. A sell-off in government debt could drive a bear bond market, which began following Trump’s election victory.

Gundlach said equities could also suffer. A 10-year Treasury above 3% calls into question certain aspects of the stock market.

Since bond prices correlate to the federal funds rate, the tightening indicates a bond rout, especially with trillions in government bonds being bid up to trading with negative yields.

Further Impact On Stocks

Changes in interest rates also affect investor psychology. When the Fed announces a rate increase, businesses and consumers oftentimes cut spending, which can cause earnings and stock values to decline.

But expected actions do not always materialize.

The economy’s condition can also affect the market’s reaction. When the economy weakens, a slight decrease in interest rates may not be enough to offset weak economic activity, causing a decline in stocks to continue. Conversely, near the end of a strong economy, when the Fed increases rates, certain sectors could continue to do well, such as entertainment and technology stocks.

No Guarantees

While the relationship between the stock market and interest rates is indirect, they tend to move in opposite directions. When the Fed raises interest rates, stocks as a whole decline, but there is no guarantee how the market reacts to a given interest rate change.

In 2013, both the S&P 500 and interest rates rose significantly, defying conventional wisdom.

Financial advisors cannot predict the stock market and its reaction to interest rate hikes. But they can advise clients to try to benefit from higher interest rates while taking into account all possible risks.

If a client has a 60/40 mix of equities and fixed income investments like bonds in a declining interest rate environment, for example, it could make sense to reverse the mix and have 60% in fixed income and 40% in equity to take advantage of higher bond prices.

Better Yields On Higher Quality Debt?

Nearly a decade of low interest rates has forced many investors to buy lower rated bonds from riskier firms in order to get a reasonable yield, pushing up prices, according to Barrons. Rising interest rates will make yields on higher-quality debt more attractive—and could result in a selloff in the lower-rated areas of the market as investors bolt riskier bonds.

Wells Fargo Securities recommended that investment grade buyers focus on higher quality debt. The bank distributed a list of trade ideas to help investors navigate through the transition. It noted that the difference in yield premiums between ratings categories like single-A and double-A is small, so investors won’t give up a lot of value. In some cases, yields could be higher even on higher-rated bonds.

For example, a 2021 bond from Lowe’s, the home improvement chain, carried single-A-minus ratings and yielded 2.49% recently. In contrast, a 2021 bond from Apple with a double-A-plus rating yielded 2.51%, according to Wells Fargo. A triple-B-minus 2022 Molson Coors Brewing bond yielded 2.94%, compared to a single-A-minus rated Anheuser-Busch 2022 bond at 3.01%.

Such trades help investors buffer against possible spikes in volatility by rotating back toward more defensive portfolios, Wells Fargo analysts wrote.

For those with a stomach to take on more risk and buy high-yield bonds, the same strategy can apply. Portfolio managers at Brandywine Global Investment Management recommended higher quality junk bonds, such as those with single-B and double-B ratings. Such bonds offer a lower risk of default than triple-C-rated debt and are easier to trade. Investors can quit their positions without assuming major losses if there’s market turmoil.

In a rising interest rate environment, higher quality junk bonds perform well, according to Brian Kloss, a Brandywine Global portfolio manager.

Some investors say the best way to deal with the accelerating pace of Fed rate increases is to stay flexible. Portfolio managers at Eaton Vance Management favored corporate bonds from emerging market countries since they offer attractive pricing and insulate investors from interest rate risks in the U.S.

The Dollar Strengthens

When higher interest rates make investing in safe, dollar denominated assets like Treasuries attractive, capital flows in from other countries, especially the emerging markets, according to Investopedia. The dollar then gains against foreign currencies, impacting trade.

The Fed’s hike also drove the dollar up against the yuan. China is the third largest US. trading partner. The dollar’s strength makes U.S. exports more expensive, putting the squeeze on the manufacturing sector.

Foreign Exchange Strategies

Changes in interest rates can affect strategies for exchanging foreign currencies for domestic currency.

If one U.S. dollar equals $1.35 Canadian dollars, it is not a good time to exchange Canadian money into U.S. dollars since the Canadian dollar will only be worth 0.65 U.S dollar. It would, however, be a good time for Americans to invest in Canadian currency when the U.S. dollar is stronger than the Canadian dollar.

When investing in foreign currency, investors still should buy low and sell high. The U.S. dollar currently equals 0.94 Euros.

Rising interest rates can strengthen the domestic currency, but they do not always. The last time the Fed raised interest rates, the U.S. dollar rose while the most recent rate hike was followed by a fall.

Long Or Short Term Investing?

When investing for the long term, investors must put aside short-term changes. If their portfolio asset mix matches investment objectives and some level of risk can be tolerated, there is no need to buy and sell frequently.

It is never smart to try to “time the market,” especially during uncertain political periods.

The Federal Reserve isn’t the only central bank raising interest rates, according to The Street.

On Thursday, Mexico’s central bank raised its benchmark interest rate for the fifth meeting in a row, increasing rates by 25 basis points to 6.50%. The increase signals confidence in the Mexican peso that has rebounded thanks, in part, to a softening of anxieties over the Trump administration’s positions on Mexico.

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Economy

Tax Cuts and the US Stock Markets

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The stock markets rise or fall on sentiment, earnings, and economic data. While the initial boost following the US Presidential elections was sentiment driven, the markets held their own as the data flow stabilized and improved in the US and around the world. However, at the current levels, the US stock markets look pricey compared to historical averages.

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Key points

  1. The markets are trading at rich valuations even after discounting a favorable tax cut
  2. Treasury Secretary Steven Mnuchin believes market will crash without a tax reform
  3. A few analysts believe that the markets will remain firm even without a tax cut
  4. We believe markets will be vulnerable for corrections if Republicans fail to pass the tax cuts
  5. Buy the rumor regarding tax cuts and sell once the news of a tax reform is announced

Nevertheless, the hopes of a tax reform have kept the markets buoyed. How much can these tax cuts add to the markets and what is the risk if the reforms are watered down or just don’t see the light of the day?

Analysts expectations for the S&P 500

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The S&P 500 is expected to end 2017 with earnings of $131 per share, increasing about 10% over 2016. For 2018, analysts expect the S&P 500 companies to collectively earn $145.2 per share.

However, there are differing views on whether these figures include the benefits accrued from the tax cuts or not. If the tax benefits are incorporated, then to what extent.

The most bullish analyst on the street, Morgan Stanley’s chief U.S. equity strategist, Mike Wilson, believes that about $9 of $145.2 in the earnings projection is based on the benefits arising out of a tax cut. On the other hand, the most bearish analyst, Weeden & Co.’s Mike Purves, believes that $14 per share is from the tax cuts.

Let’s take a bullish scenario.

Analysts expect the annual per-share earnings to increase by $15 if the corporate taxes are cut from 35% to 20%.

However, Wilson has only accounted for $9 in benefits from the tax cuts. Therefore, we will have to add another $6, which gives us a figure of $151.2.

So, in the most bullish scenario, at 2580, the S&P 500 is trading at a forward p/e of 17 times.

Factset data shows that the 5-year average and 10-year average forward earnings P/E ratio of the S&P 500 is 15.6 and 14.1 respectively. Therefore, even with the most optimistic scenario of earnings built in, the S&P 500 is currently trading above its past averages.

However, just because its current valuations are above the historical averages will not cause a correction in the markets. But, can a failure to pass the tax cuts start a fall?

What if the tax cuts don’t see the light of the day or are diluted in their effect

Again, we shall consider the most bullish scenario. If the Republicans fail to pass the tax reforms, then the earnings projection for next year will fall by $9, to $136.2. At that level of earnings, the S&P 500 is currently trading at a P/E of $18.9, which starts to look pricey.

What level was the S&P 500 trading prior to the two previous crashes of 2000 and 2007?

As seen in the chart sourced from yardeni.com, the S&P 500 is already trading at a higher forward P/E than 2007. This confirms that we don’t have the comfort of valuations behind us. However, we are still a distance away from entering into a bubble territory when compared with the forward P/E of 24, recorded during the heights of the dotcom bubble. Therefore, a crash might not be in the offing.

How much will the S&P fall if the tax reforms don’t go through

Here again, there are two schools of thoughts. While one says that a failure to ring in the tax reforms can easily plunge the S&P 500, others believe that the stock market is unlikely to fall more than 5%.

Treasury Secretary Steven Mnuchin believes that a lot is riding on the tax reforms. In a podcast with Politico he said: “To the extent we get the tax deal done, the stock market will go up higher. But there’s no question in my mind that if we don’t get it done, you’re going to see a reversal of a significant amount of these gains.”

However, Credit Suisse and Morgan Stanley differ, as they don’t see a market crash even if the tax reforms fail.

“The market rewarded firms with high effective tax rates for only three weeks post-election, but not since,” wrote Jonathan Golub, Credit Suisse’s chief U.S. equity strategist. “For that reason, we do not believe that stocks would be at risk if a deal isn’t struck,” reports CNBC.

In a note to its clients, Morgan Stanley has painted three different scenarios with no tax cuts, modest cuts, and substantial cuts.

Morgan Stanley believes that the markets will only fall by 1% if the tax cuts don’t happen.

What do we believe?

We believe that the US market rally in the past year has been driven by hopes of a fiscal boost and tax reforms. These have kept the sentiment positive. As a result, the markets have risen on favorable economic data in the US and around the world and has not given up ground even when the news was unfavorable.

However, after failing to repeal Obamacare, if the Republicans fail to push through a meaningful tax stimulus, the sentiment will be dented.

That will leave the markets vulnerable to sharp drops on any adverse news because the floor of the reforms and an earnings increase will be lost.

On the other hand, if the tax reforms are announced, the markets are certainly likely to surge in the short-term, however, the bump up is unlikely to last for more than a few weeks. Usually, experienced traders buy the rumor and sell the news. We expect the same to repeat once the reforms are announced.

The markets will correct and the focus will shift to the effects of the stimulus at this stage of the recovery, which has been questioned by many economists. The Federal Reserve may also have to tighten at a faster pace than expected, which may neutralize some of the effects of the rate cuts.

Bottom line – To buy or to sell?

Buy the rumor of a substantial tax cut. However, once the cuts are announced, please book profits in the ensuing buying stampede.

On the other hand, if the tax cuts fail to materialize, keep the buy list ready to enter on any fall, which is closer to 8% to 10%.

Featured image courtesy of Shutterstock. 

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Economy

U.S. Nonfarm Payrolls Unexpectedly Decline in September

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The U.S. job machine slowed significantly in September, as Hurricanes Harvey and Irma ripped through the southern states, disrupting local economies in their wake.

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Overall nonfarm employment fell by 33,000 last month, following a revised gain of 169,000 in August, the Department of Labor reported from Washington. Analysts in a Bloomberg survey forecast an increase of 100,000.

The jobless rate declined to 4.2% even as workforce participation rose. That’s a level not seen since 2001.

Signs of wage inflation were present last month. Average hourly earnings rose at a faster 0.5% on month and 2.9% annually, official data showed.

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Earlier this week, payrolls processor ADP Inc. said U.S. private sector employers added 135,000 positions last month. Economists had projected 98,000.

Hurricane Harvey made landfall in Texas at the end of August, triggering the biggest weekly spike in jobless claims since 2012. A total of 298,000 Americans filed for state unemployment benefits in the week ended Sept. 2, a gain of 62,000 from the week before.

September was the first negative reading on payrolls in seven years. Hiring is expected to rebound in the fall as the states of Texas and Florida resume cleanup efforts in the wake of hurricane season.

Solid employment growth has been one of the few mainstays of the U.S. economic recovery, prompting the Federal Reserve to gradually normalize monetary policy. The Fed is widely expected to raise interest rates again before year’s end. The Fed’s “great unwind” of its balance sheet will begin this month at a rate of $10 billion.

The report had no immediate impact on the currency markets, with the U.S. dollar index (DXY) rising gradually shortly after the data were announced.

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BOJ Rate Decision: Bank of Japan Keeps Policy on Hold After September Meeting

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The Bank of Japan (BOJ) has voted to keep its trend-setting interest rate at record lows, as policymakers continue to rely on record stimulus to keep the economy humming.

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BOJ Policy Decision

In an 8-1 vote, the BOJ kept its benchmark interest rate at -0.1%, where it has stood since January 2016. The decision was widely expected by economists, who say the BOJ is unlikely to budge on monetary policy anytime soon.

The BOJ also maintained its purchase of Japanese government bonds (JGBs) so that the 10-year JGB yield remains at zero percent. Meanwhile, annual bond purchases continue to be held at ¥80 trillion.

The BOJ shifted course on monetary policy last September when it made yield-curve targeting its central concern. Since then, it has been status quo.

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Economic Picture Brightens

Central bankers have been largely hands-off to let monetary policy do its job. Recent data suggest ultra-loose policies are finally having their desired effect. Japan is currently in the midst of its longest period of uninterrupted growth in more than a decade. Quarterly gross domestic product (GDP) expanded 0.6% between March and June, the fastest in more than two years.

In annualized terms, the economy expanded 4% in the second quarter, official data showed. That was much bigger than the 2.5% annualized gain forecast by economists.

Japan has now been on the right side of growth for six consecutive quarters and nine of the past 11.

Strong domestic demand and a synchronized global recovery lifting Japanese exports have been the main factors behind the growth.

Despite solid growth, inflation continues to lag the central bank target of 2%. Core inflation rose in July for the seventh straight month, but came in at just 0.5%. National CPI also expanded 0.5% annually in July for its seventh straight gain.

Inflation has been so disappointing that the BOJ recently postponed its inflation deadline for the sixth straight time. The move highlights the growing frustration with low inflation under the Abe regime.

Yen Losing Ground

Japan’s currency declined again on Thursday to trade at fresh two-month lows. The dollar-yen (USD/JPY) exchange rate reached a session high of 112.65 before paring gains. At the time of writing, the pair is up 0.2% at 112.51.

The yen has been in free-fall for the past two weeks as risk sentiment returned to the financial markets. The yen is a highly liquid reserve currency that usually receives strong bids during periods of instability. With investors pouring money into stocks, the yen has fallen by the wayside in recent weeks.

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