HOUSTON, DO WE HAVE A PROBLEM? What will happen when interest rates rise? How will it affect your portfolio and the economy at large? This month we consider the potential disruptive force of rising U.S. interest rates and suggest a time-tested strategy for protection.
In the latest bout of volatility, long-term interest rates in the United States climbed by almost 0.4 percentage points. Ten-year U.S. Treasury bonds are yielding 2.39%, up from 1.97% in late March. International long-term interest rates, particularly in Germany, have climbed even more steeply. The 10-year Bund yield briefly brushed the 1% level in early June after trading as low as 0.08% in April. Some pundits suggest that a generation-long shift toward ever-lower global interest rates may have finally run its course. Have world bond markets reached the tipping point? Opinions are divided, and only time will tell. What’s the average investor to do? Our advice—regardless of what financial pundits suggest—is that the best defense against uncertainty is a sound financial plan. Remain consistently disciplined and follow an investment strategy tailored to your goals and risk tolerance. Disregard the noise of the markets and so-called experts. Adopt a long-term focus. Be patient. And if the eventual departure from low interest rates triggers a downdraft, assume a rebalancing opportunity. Below we take a look at the risks to financial markets in the aftermath of quantitative easing. But first, let’s review the numbers from May.
The S&P 500 returned 1.29% for the month, and closed the period with a 3.23% YTD gain. The S&P MidCap 400 outperformed other core domestic equity indices in May, adding 1.78%, and had the highest YTD return, at 5.59%. The S&P SmallCap 600 returned 1.53% for the month, with a 3.10% YTD return.
Developed Markets outside the US returned negative 0.51% for the month, after April’s positive 4.08% return, finishing the period with an impressive 8.6% YTD return.
As a group, Emerging Markets performed poorly. With most markets in the red, the Emerging Market index returned negative 4% for in May, but remained up 5.69% YTD.
Global Real Estate securities declined 1.23% in May, as flat U.S. returns saved them from greater loss. YTD non-US Reits finished May with positive 1.98% versus negative -1.39% YTD returns for domestic Reits.
Interest rates increased for the month, as the U.S. 10-year Treasury bond closed at 2.13% from last month’s 2.03%. The U.S. 30-year Treasury bond closed at 2.89%. Gold closed at 1,190.50. Oil closed at $60.23. U.S. pump prices increased, to end the month at $2.77.
ASSESSING RISK: WHAT HAPPENS WHEN U.S. INTEREST RATES BEGIN TO RISE?
Ever since the global financial crisis, central banks around the world have reduced interest rates and embarked on asset purchases in an attempt to lift inflation and restart economic growth. Monetary policy makers have marched on a common path, which has been reassuring to investors. But that path is expected to diverge this year.
After years of decent growth and significant falls in unemployment, the U.S. Federal Reserve and the Bank of England have finished their quantitative easing programs and are leaning toward in the first interest rate increase in nearly 10 years. Conversely, the European Central Bank is in full monetary loosening mode. In Asia, the Bank of Japan is preoccupied with its bond-buying program, while the People’s Bank of China has cut interest rates three times in six months.
One troubling question facing the world economy is exactly when the U.S rate lift-off will take place. Economists fear the damage arising from a premature tightening by the Fed would trigger a new recession, hurt exporters around the globe, hit investment and shake confidence. While it remains entirely possible that this is not a bond market tipping point, monetary divergence is inescapable as long as the U.S. economy gathers momentum. But it need not be damaging.
History suggests that when the Fed raises rates, the manner in which it does so is critical. For example, consider two episodes under Alan Greenspan, noted by John Authers in the Financial Times. In 1994, rates rose swiftly, against expectations, and drove up longer-term yields while keeping the stock market flat. A decade later, in the aftermath of the dotcom bubble, Greenspan did it differently. Interest rates rose by increments of 0.25 percentage points at every meeting the Fed held for years. Long-term yields actually fell, while stocks rallied.
We all hope that policy makers will have the wisdom to ensure a smooth transition to a new phase of monetary policy, neutralizing the risk of adverse impacts to the global economy. But whether they do or not, you have the tools to be well prepared.