Will Higher Interest Rates Derail Stocks?

Continued economic growth has led the Federal Reserve to raise the Fed Funds rate to 2.25%.  This is the biggest issue facing asset markets right now even though the rate remains well below levels that led to recessions twice during the last 18 years.  For that reason, I believe the Fed is going to be cautious with moves above 3%.  Remember, one of their stated goals initially was to be able to “normalize” short-term rates.  I believe they will have accomplished that goal when they reach 3%.

Stockcharts.com, Dightman Capital

The 30-Year Treasury bond broke price support with the latest Fed announcement which pushed up interest rates at the long end of the curve.  The silver lining for the current rate environment is a steepening yield curve.  The interest rate spread (the difference between short-term and long-term rates) makes it possible for banks to borrow at low rates and lend at a higher rate.  A strengthening banking sector should benefit the broader economy.

Here is a look at the Treasury market yield curve and 30-Year Treasury Bond price chart.

Stockcharts.com

Real estate price appreciation should also slow as financing costs rise.  There is some evidence in certain markets that price increases have slowed or stalled.  Stocks too, will compete with higher bond yields as rates move higher (more on this below).

In terms of Inflation, globalization has kept most inflation measurements in check (aside from asset prices like real estate and stocks).  Low inflation should provide the cover the Fed needs to slow rate hikes in 2019-20.  On the operational side, companies do benefit from low and stable input costs, which helps drive earnings growth.  An increase in input costs could result in higher prices.

Trade disputes may influence inflation but it could be temporary in many cases.   There remains a lot of capacity in the world so moving production, for example, out of a country is an option for some.  Other products might require special machinery or expertise and those product markets might see higher prices, potentially much higher.  Those individuals in the market for new electronics might want to make a purchase now if higher prices is a concern.  It is possible we could see higher prices in a wide mix of products from trade negotiations; so far the effects have been negligible.  Early 2019 is when we might start to feel the pricing pressure from ongoing trade disputes.

The U.S. Economy remains healthy; October started with a trio of good news.

  • The ADP payrolls report hit 230,000 in September, beating estimates
  • The Purchasing Managers Index for Services in September came in at 53.5, above the 52.9 consensus
  • September’s Institute for Supply Management hit 61.6 for the service sector, ahead of the view at 58

The U.S. Stock Market continues to like the economic environment.  Three months remain in 2018 and if stocks can hold on to the gains they have generated, it will be a decent year.

It is important to remember a diversified portfolio will have a mix of investment returns.  While certain parts of the stock market are delivering nice returns, some categories are under performing.  Many dividend stocks have not had a particularly strong year.  Bond yields are part of the reason.  The relative safety of bonds, combined with their now higher yields, compete with stock dividend yields.  Also, value stocks are not favored in the current environment; both of those factors should eventually become attractive as market character shifts.

Earnings-Growth Expectations for Q3 remain strong.  The view from FactSet  suggest earnings growth between 20-25% for the period.

So no, I don’t believe stocks are going to be derailed by higher interest rates in 2018.  We remain in a very constructive economic environment despite ongoing trade negotiations.  As we start Q4 stocks have pulled back; expect more selling in the days and weeks ahead.  This is a normal and healthy process which should eventually allow stocks to rally as 2018 comes to a close.  Don’t be surprised if this pullback ends up being 5-10% deep.  Primarily due to interest rates and trade talks.  As of the close on October 8th, the S&P 500 was down less than 2%.

Posted in Central Banks, Credit Markets, Dightman Capital, Economic Analysis, Government Policy, Interest Rates, U.S. Bonds, U.S. Stock Market and tagged , , , , .

Brian Dightman