Rising Rates Eventually Good for Bonds…But Will They Send The Bull Back to the Barn?

Since 2009, global stock investors have been experiencing a powerful advance in stock prices — this past year was no exception. Most of this advance has been fueled by the tremendous value created in stock prices after the catastrophic decline in 2008. However, it has also been supported by the accommodative policies of global central banks and their insistence on keeping interest rates at historically low levels. In recent months, we have witnessed a number of changes taking place in regard to the fundamentals of the global economy and the market for stocks, bonds and real estate. Each of these changes will eventually impact the direction of these asset classes.

The first and most important fundamental change we see from our data is that global economic growth is beginning to pick up pace — finally! This appears to have momentum and may last years not months. Throughout the past five years of this expansion, economic growth has been subpar by just about every measure. The unemployment rate would be the most obvious data point supporting this case. However, the recent upturn in growth, both here and abroad, is supported by a real recovery in real estate and manufacturing — two key elements to a healthy economic expansion. The US government’s ability to agree on the budget crisis supports this view as well. These types of economic and fiscal changes usually lead to better corporate profits, reduced unemployment and enhanced corporate and consumer confidence; all of which fuel further growth down the road. Of course, there may be something unexpected that could derail this rosy scenario and throw the globe into recession. However, at this point, our leading indicators remain quite positive.

A stronger global economy has several effects on stock prices, interest rates and real estate. Stock prices are fundamentally driven by corporate earnings and the possibility of stronger economic growth supports the case that stock prices can go higher from these levels. Huh? Is that possible you say? Yes. However, the future trajectory of stock prices will likely be less steep than we have witnessed over the past 12 months and will have corrections along the way — we may be overdue for one as we write this. There is quite a bit of data, beyond stronger future earnings, to support higher stock prices. First, stocks are still reasonably priced at a price earnings ratio (P/E) of 15.5. The bull usually runs out of energy at a higher P/E ratio. Second, many investors have missed most of this bull market and, therefore, bond fund and money market balances are at historically high levels. We believe that some of these investors have begun to move these funds into stocks — with much more to come — which would drive stock prices higher. Some argue that higher interest rates (which we predict and comment on below) will send the bull back to the barn. However, history and our research suggest that the stronger economy will win out for the first one to three years and that the bull can survive a number of rising rate periods.

A stronger global economy will cause central banks to quit their policy of low rates which will effectively allow rates to rise to more normal levels — this has already begun. This will cause intermediate and long maturity bonds and bond funds to lose value and could be a long lasting decline. Therefore, we do not abdicate investing in this part of the bond market. However, as rates rise, it does allow us to buy high quality shorter term bonds with reasonable yields — something we have been unable to do for the past few years! So a stronger economy and higher rates will be beneficial to the fixed income investor over the next few years.

Our research suggests that the real estate recovery is alive and well and that stronger economic growth will continue to support this trend. However, rising rates will likely reduce the speed and trajectory of the recovery.

The current economic expansion is in its fifth year. Given all of our positive commentary throughout the past few years and in this strategy update, all investors must remain cognizant that economic expansions do not last forever (usually about 7-9 years) and always end in recession — which is really bad for stocks. Though we do not foresee a recession in 2014, we must be mindful that in the next few years a recession will become more and more likely. Therefore, we will continue to use our risk management tools which include your portfolio’s asset allocation, sector management and the use of carefully placed stop loss orders — all of which are employed to mitigate the risk of a catastrophic decline.

All of us want to thank you for the confidence that you have placed in our team and we wish you and your families a healthy and prosperous 2014. If you have experienced a significant change in your financial circumstances recently, please let us know.

Sincerely,

Your Team at Main Street Research