As we know, uncertainty about the Fed’s plans for raising short-term rates remains a key driver of market volatility. It’s understandable that investors are afraid to be in the markets and at the same time, afraid to be out. Whenever rates do rise (probably before the end of the year), there’s every reason to expect continued heightened equity market volatility. Even so, I view a more normal interest-rate environment as long-term positive—for the economy and for the equity market.
Here are some points to keep in mind.
- Higher short-term rates should be viewed as an affirmation of U.S. economic health. The Fed has consistently expressed its commitment to a patient, globally informed, data-driven approach. It will raise rates when it believes the U.S. economy is strong enough to continue growing without artificially low rates.
- The “path” of short-term rate increases is likely to be slow and shallow. In other words, I don’t believe we’ll see the Fed move to raise rates significantly and many times, provided that the overall economic landscape remains consistent with what we’ve seen over recent years—slow growth, low inflation.
- A more normal interest rate environment can support continued economic growth, particularly among smaller businesses. When interest rates are higher, lenders can earn more from borrowing activities. This should provide an increased incentive to lend to small businesses, especially against the supportive backdrop of continued economic growth. With increased access to capital, small businesses can grow and hire more people, contributing to better overall economic growth.
- Higher short-term rates don’t signal that we’ve entered a bear market. Earlier, I noted that markets are likely to remain volatile when rates rise, but that doesn’t mean there won’t be opportunities, especially for long-term investors who take an active approach. Historically, stocks tend to perform well during periods of economic growth (see point #1). Stocks have continued to advance after the onset of an interest rate increase, as Figure 1 shows.
Figure 1. S&P 500 Returns After Rate Hikes
Past performance is no guarantee of future results. Source: Cornerstone Macro. “Positioning For A Fed Tightening Cycle,” September 16, 2015.
- Convertible allocations may be particularly effective in this sort of environment. Because they have fixed income characteristics, convertibles may be able to mitigate the impact of short-term equity downside. And because they have equity characteristics, convertible securities generally demonstrate less vulnerability to interest rate increases than investment grade bonds. That means that when rates do rise, allocations to convertibles may prove more resilient. (Co-CIO Eli Pars outlines more of these potential benefits in this video interview.)
It’s been observed time and again that markets hate uncertainty. That’s not likely to change. More importantly, what’s also not likely to change is this: volatility creates opportunity for those who can tune out the short-term noise and take a long-term view.