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Threading the Needle on Interest Rates

April 10, 2018

 

Why do stocks go down when interest rates go up? Because all assets are priced as the present value of their future cash flows and interest rates are the discount rate used to calculate this present value: the higher the interest rate, the lower the long term value of these cash flows. For example, a fixed 5-year asset that pays $5 each year and $105 in year five has a present value (what it is worth today) of $109.16 when interest rates are 3%. However, if interest rates rise to 6%, this same asset would have a present value of $95.79.

 

 

When economies are strong, there is more demand to the point where it can create higher prices of all assets, especially when there is access to inexpensive borrowing. This forces central banks to raise rates, making borrowing much more expensive which in turn reduces demand and lowers prices of all assets, such as stock prices. This is why often stocks go down when the economy is at its strongest and just about to weaken due to rising interest rates, eventually representing the end of the business cycle. This is also why it is best to sell stocks when things never looked better!

 

Conversely, when economies are weak, the central bank lowers rates to stimulate borrowing to create demand. Therefore stocks go up because their cash flows are increasing and in the future will be worth more due to the lower rates.  This is why it is best to buy stocks when things never looked worse!

 

When interest rates start to go up, stocks will still go up as long as their cash flows are rising  fast enough to more than offset  the increase in interest rates [Refer to our blog post “The Three Pillars” for a more detail explanation to why this is]. However if cash flows start to slow faster than the interest rate increase, and valuations are already high due to many years of rising stock prices, then this will lead to lower values for stocks and their prices will fall accordingly. The pain of course will be worse if those stocks were purchased with debt (on margin).

 

The difficulty is always trying to figure out where one is in the cycle and how to allocate assets between  stocks, bonds and cash at the right times. This is no less difficult for the Central Banks that have the job of increasing or lowering interest rates in order to sustain non-inflationary economic growth and good job growth to provide stable employment and a more prosperous nation.

 

Right now what is going on in the US is highly unusual because the government is stimulating the economy (with tax cuts and increased spending on the military and other programs) at a time when the economy is already strong. Generally, if the economy is already operating relatively close to full capacity this leads to too excessive demand and runaway inflation, eventually leading to higher rates . This situation is made worse as the Federal Reserve tries to normalize interest rates from the artificially low levels maintained since the financial crisis, as they are no longer necessary to support the economy. Higher rates are without doubt the new central investment issue for 2018. The only question is how high can they go, before the economy comes to a grinding halt and creates the next recession. Rising rates and high debt levels are never a good combination. Given the high indebtedness of governments, corporations and indeed the general public, our sense is that it will not take much higher rates to bring the economy to a grinding halt.

 

Running big government deficits make interest rates go up.  Everyone was worried when the debt levels reached 60% of GDP and now that the number is over 100% nobody appears overly concerned, yet it is a bigger concern. Deficits bring crowding out because government borrows before you and I do, and is insensitive to what rate of interest it pays,  so if they borrow so much that it pushes up interest rates by x%, then your mortgage will go up a corresponding amount or more.

 

 

As a result, this could well be the beginning of the end of the 30 year bull run in the bond market.

 

We believe the uptrend in interest rates will be inevitable for several reasons:

 

  • The inflation outlook is rising following a large drop in the trade weighted value of the US dollar.  This is due to a $1.5 trillion tax cut stimulus at a time of full employment, and tariffs being initiated on US imports as the Trump administration seems intent on starting a global trade war. This is compounded by the increasingly reckless fiscal mismanagement of Congress and the Trump administration.

 

  • The Federal Reserve is out of bullets to create money out of thin air by undertaking additional asset purchases to dampen the rise in bond yields.  In fact, the Federal Reserve is now intent on unwinding their trillion dollar asset purchases, invariably adding upward pressure to bond yields. The Federal Reserve is no longer a “buyer at any price.”

 

  • The size of the US Federal deficit makes it very sensitive to the rate of interest given the outstanding debt principal rolling over annually.  Any rise in rates will exacerbate the size of the Federal deficit by forcing the government to pay higher interest and thus further increase the requirement for more debt, adding upward pressure to bond yields. Any other country or even corporation with such poor financial discipline and recklessness would have a high credit risk. The US has gotten by unscathed as they have never defaulted. As the world reserve currency people are forced to hold dollars even when they show that they do not have the best financial discipline.  This could change as China gains more power on the world stage at a time when the long held belief that US government debt is risk free (which implies a zero percent chance of default) may start to be challenged.      

 

  • The foreigners who are the marginal buyers of US treasuries, may no longer be interested given the ongoing depreciation in the value of the US dollar and rapidly deteriorating fiscal outlook. In fact they could even sell their existing treasury holdings to avoid losses, bringing more downward pressure to the dollar and upward pressure to interest rates. This may be particularly true in an era of trade wars and the potential for other currencies to gain reserve status.

 

Regardless of why it happens, what is clear is that as interest rates climb the economy will slow, quickly dampening the outlook for earnings growth and ultimately reducing the upward pressure on rates.  In fact, given the overall level of outstanding debt in the US, the US economy could slow very fast, should short term and long term yields rise too much due to the drag of higher debt servicing costs.

 

There is a lot of nonsense talk about how lower taxes will offset all of the above because corporations are the biggest recipient of the tax cut and they will expand and hire more people. History shows that when rates rise, it quickly reduces the attractiveness of future capital expenditures due to a weakening economic outlook.  Corporations will be very quick to cut back spending and hoard cash. The dynamic is very different than a consumer tax cut, as consumers are more prone to spend unless they must service their debt.

 

Ultimately, we do not think the math supports rates going higher than the 3.5% level. This is in line with historical averages of around 4%. It is also probably in line with the maximum number the economy can support given current debt levels.  When rates reach this level or higher, we would expect for the earnings outlook to downshift rapidly if we see a loss of economic momentum. A scarcity of earnings growth will resume a narrowing of the stock market once again.

 

In a best case scenario, interest rates will hover around this level to give the economy some time to adjust to the new reality. If this is the case, the bloodletting in the bond market could be manageable. But if the economy heats up, pushing inflation upwards, or if the government continues to spend aggressively, the blood bath in bonds, particularly high yield bonds could be extremely painful.

 

As long as we live in a world dominated by debt as we have since the beginning of the century, things will remain the same: slow growth at best, as that debt eventually does have to be paid off.  This leads us to continue to believe that only secular growth stories will prevail in the stock market.  We remain of the view that this is not the time to be a hero: one must avoid highly levered corporations, long term bonds of any type of description and own only the best companies.  These companies will be able to weather the storm that will be caused by rates trending higher because, not only do they not need to borrow money,  they should also be able to deliver high enough growth rates in earnings and dividends to offset the rising yields offered by bonds. 

 

The Summerhill Team

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