Leigh Lowman, Investment Manager
In a widely anticipated move, the Fed increased interest rates by 25 basis points on March 15, 2017, the second interest rate hike in three months and there are talks of potentially two more raises this year. Positive economic data and a rise in business confidence served as a catalyst for the Fed to continue its interest rate normalization efforts with the possibility of as many as two additional rate increases later this year. However, recent rhetoric from the Fed reaffirmed their commitment to move at a cautious pace, supporting Brinker Capital’s view that the process of longer term rates will likely be prolonged and characterized in fits and starts, rather than linear, as the market adapts to the new normal.
Catalysts for higher interest rates
Many positive factors are currently present in the economy that point to a move toward interest rate normalization:
- Stable U.S. economic growth. Economic growth in the U.S. has been modest but steady. The new administration and an all-Republican government will likely further stimulate the economy through reflationary fiscal policies including tax cuts, infrastructure spending and a more benign regulatory environment.
- Supportive credit environment. High yield credit spreads have meaningfully contracted and are back to the tight levels we saw in 2014. Commodity prices have also stabilized.
- Inflation expectations. Historically, there has been a strong positive correlation between interest rates and inflation. Many of the anticipated policies of the Trump administration are inherently inflationary. Inflation expectations have increased accordingly and headline inflation has been moving towards the Fed’s 2% long-run objective. In addition, we believe we are in the second half of the business cycle, typically characterized by wage growth and increased capital expenditures, both of which eventually translate into higher prices.
- Unemployment levels. The labor market has become stronger and is nearing full employment. Unemployment has dropped to a level last seen in 2007.
From 1965 to present, the Fed has implemented policy tightening a total of 15 times and the impact on the bond market has not always translated into longer rates rising. For example, back in 2004 the Fed began raising rates in response to beginning concerns of a housing bubble and the bond market did well as the yield on the 10-year Treasury fell.
More recently during the current market cycle, the Fed increased rates by 25 basis points in December 2015. The 10 year Treasury yield fell and the bond market generated a positive return while equities plummeted in the first quarter of 2016. A year later, the Fed increased rates by 25 basis points in December 2016. The impact on markets was minimal with both equities and fixed income generating strong positive returns in the two months that followed.
Fixed income allocation
Traditional fixed income has historically provided a hedge against equity market risk with substantially less drawdown than equities. Although a rising rate environment would suggest flat to negative returns for some areas of fixed income, the asset class still provides stability in portfolios when equities sell off. For example, fixed income provided an attractive safe haven during the market correction in the beginning of 2016.
In an environment of rising rates, Brinker Capital believes an allocation to traditional fixed income is still merited as we expect the asset class to provide a good counter to equity volatility.
Overall, much uncertainty remains on the timing and trajectory of interest rate changes. Brinker Capital remains committed to helping investors navigate through a rising rate environment through building diversified portfolios across multiple asset classes.
The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Brinker Capital, Inc., a Registered Investment Advisor.