Rising Rates Can Cause the Wrong Reaction
When expecting an interest rate increase, many investors believe that they should shift assets out of "risky" investments such as stocks and high-yield bonds and into "safe" investments, such as Treasury bonds or high-grade corporate bonds. However, during periods of rising interest rates, high-grade long-duration bonds typically decline in value.
Historically, Rising Rates Haven't Affected All Asset Classes the Same Way
According to a study by Citigroup that looked at the past five periods when interest rates rose by more than 100 basis points, interest-rate sensitive issues, such as Treasury bonds and high-grade corporate bonds, were adversely affected, while equity-sensitive issues had strong relative and absolute performance.
1Source: Citigroup
For Equity-sensitive Securities, Other Factors Predominate
- Stock market appreciation
- Mergers and acquisitions
- Credit quality upgrades
- Special situations
Our Constructive Outlook
How you respond to an interest rate increase depends on your economic outlook. Some investors believe that the economy is weakening and that a rate rise will choke growth, and so are ready to board the flight to quality. In contrast, our outlook is constructive, and we believe that rises in interest rates are the by-product of a strengthening and sustainable economic recovery. It is our opinion that the appropriate response to a possible rate rise is to increase equity sensitivity.
Below, we discuss the reasons for this outlook and our belief in the appropriate portfolio positioning in this environment.
GDP growth for the first and second quarters of 2004 was 4.5% and 3.3% respectively, following a 4.2% increase in the final quarter of 2003, and 7.4% in the third quarter of last year. GDP results continue their positive trend. We believe that corporate earnings, profitability and other key ratios show that the economic recovery is not only real, but sustainable.
2Source: Bureau of Economic Analysis
Favorable Macroeconomic Trends3
Increasing:
- Cash flow to net sales
- Cash flow to interest expense
- Profit growth
- Industrial production
- Order backlogs
- US exports to China
Decreasing:
- Long-term commodity price trends
- Inventory to sales ratio
- US factory job losses relative to other nations' experience
Strong Demand in the Manufacturing Sector
The PMI continues to indicate an expansion of the manufacturing economy, with 17 consecutive positive (at or above 50%) figures.
4Source: Institute for Supply Management (ISM), PMI-History
Consumer Demand Pulling Through the Economy
Contrary to media reports in an election year, reliable indicators show continued economic strength. According to the Department of Commerce:
- Shipments increased in June, July and August
- Unfilled orders increased in June, July and August
- Inventories rose in June, July and August
We think these figures show how, after a lull in April and May, consumer demand is still pulling through the manufacturing sector, as businesses produce, ship and store more products, anticipating future sales.
Earning VS. Expectations: Another Record Quarter5
According to Thomson Financial/First Call, the first quarter of 2004 set a record for both the number of companies whose actual reported earnings were ahead of expectations (76%), and the amount by which these companies beat expectations (8.4%). For comparison, Thomson reports that historically, about 58% of companies beat expectations by an average of 3%. Most notably, 83% of firms in the economically sensitive cyclical sectors reported earnings ahead of expectations, and those earnings were an impressive 22% beyond estimates.
Figures for the second quarter were also positive, with 69% of companies coming in above estimates, 16% matching and 15% falling below estimates. That compares to a typical quarter, in which 58% beat estimates, 22% match and 20% miss. Notably, the second quarter was the fourth consecutive with earnings growth of 20% or better for the S&P 500, something that has only occurred twice in a quarter century.
Productivity Drives Growth Past Rising Rates6
Lost in the discussion of any potential interest rate hike is the fact that we are in the up or wealth creation phase of the economic cycle. True, there is greater demand for capital, which leads to higher interest rates. At the same time, productivity is increasing. For the second quarter, productivity increased by 6.9% in manufacturing, 4.9% in durable goods manufacturing and 9.7% in non-durable goods manufacturing.6 As a result, ROIC is increasing at a rate faster than the cost of capital; as the engine of growth, this ultimately drives the market.
Put Any Possible Rate Increase in Context
Given the length and strength of the economic recovery, some investors are predicting an interest rate increase followed by an economic slow down. While we agree that a short-term rate hike is likely, we believe that the current low inflation environment can withstand modest rate rise because:
- Counteracting, deflationary pressures persist
- Growth should dilute effects of rate rise
- Credit quality upgrades should affect performance more than inflation.
Constructive Outlook Compels Equity Sensitivity
Moving assets out of equity sensitive investments such as stocks, convertible securities and high yield bonds could be the wrong reaction to a rate rise. With a constructive outlook on the economy, one can enhance potential gains by increasing the equity sensitivity of a portfolio, adding to stock, convertible and high yield holdings.