Economic and Financial Market Commentary: Q3 2018

Kevin Ervin, CFP®, CPA

After a generally positive investment environment for the third quarter, both stock and bond asset classes have come under pressure in the first couple of weeks of the fourth quarter. The primary catalyst responsible for both the bond and stock market declines in early October has been rising interest rates. Much of this commentary will focus on the subject of increasing interest rates.

Before our discussion on interest rates, please see the table below that summarizes major index returns for the third quarter, the past 12 months and annualized returns for the past 3-year period for some of the major asset classes.

Federal Reserve Bank and Interest Rates

The Federal Reserve Bank has a dual mandate of helping the US economy achieve full employment and also controlling inflation. Often these goals conflict with one another as a tool to help reduce unemployment can have an unfavorable impact on inflation.

The primary tool utilized by the Fed is the influencing of interest rates. Their most direct influence is by establishing the Fed Funds rate. This highly publicized action controls the short-term rates that banks charge to lend funds to one another, which then impacts the interest rates that banks charge their borrowers. Changes in short-term rates do not necessarily lead to corresponding changes in longer-term interest rates. For example, during the last 3 years, the overnight Fed Funds rate has increased over 2% while the 10-year US Treasury rate has only increased approximately 1%.

The Fed’s control over longer-term interest rates is less direct, but still very effective. The Federal Reserve Bank owns over $4 Trillion of US Treasury and Government Agency debt securities. The Fed imparts its impact on the level of longer-term interest rates by varying how much of the securities it buys and sells. Before the financial crisis hit in 2008, the Fed owned only $1 Trillion of debt securities. To help the national (and really the global) economy out of the crisis, the Fed significantly increased its purchases and holdings of securities in multiple phases (“quantitative easing”). This jump in purchasing increased demand for the debt securities, which increased the prices of the bonds, causing a decrease in the effective interest rates. Just another reminder, there is an inverse relationship between interest rates and bond pricing. The lower interest rates that resulted from the Fed’s action helped stimulate economic recovery following the financial crisis of 2008.

After many years of accommodating monetary policy and low interest rates following the financial crisis, the Fed has been slowly returning to a more neutral monetary policy to help prevent inflationary pressures from building in the US economy. The return to a more neutral policy has been accomplished by the gradual increases to the Fed Funds rate (short-term rates) and gradual sales of US Treasury and Government Agency bonds from the Fed’s balance sheet (longer-term rates).

Inflation has moved up only slightly in the past couple of years, but there are increasing concerns of potential greater pressure in the future. Today’s extremely low unemployment rate of 3.7% reflects an economy that is growing at a faster rate than the workforce. The size of the workforce has been constrained by both demographics (retirement of Baby Boomers) and immigration reduction. The increasing willingness of the US government to impose tariffs on imported goods will likely lead to higher inflation on certain products and sectors.

Interest Rates Impact on Economy

Rising interest rates tend to have negative impacts on most parts of the economy. Some of the impact is felt almost immediately, while other effects take time to work their way through the economy. Some of the most immediate impact is felt by borrowers with floating interest rate loans. While this has a larger impact on businesses, many homeowners have home equity lines of credit that have floating interest rates.

Many homeowners also have adjustable rate mortgages. The loans have rates that are fixed for a set number of years, often five or seven years, and then reprice based on interest rates in effect at the time of adjustment. For borrowers that took out these loans five or seven years ago, they will likely be faced with higher monthly mortgage payments.

As both consumers and businesses must commit more cash flow to interest payments, they have less funds available for consumption (less demand). As demand weakens, inflationary pressures begin to decrease, which helps the Fed achieve its goal of preventing higher levels of inflation.

The housing market tends to be very susceptible to higher interest rates. An example will illustrate this. A prospective homebuyer who budgets a monthly principal and interest payment on a 15-year mortgage of $2,000 per month, can afford a mortgage loan amount of approximately $290,000 with a 3.00% interest rate. This interest rate was attainable just a couple of years ago. Current interest rates for 15-year mortgages are closer to 4.50%. At this higher interest rate, the above prospective home buyer can only afford a $261,000 mortgage amount for the same $2,000 monthly payment budget. This scenario will tend to at least slow increases in home prices, if not cause an outright decline, as sellers reduce their selling price expectations to meet the budgets of the pool of prospective buyers.

In addition to businesses and consumers, rising interest rates can negatively impact the federal government. For the past decade, the US Government and its agencies have been able to issue debt at historically low interest rates. However, every week, billions of dollars of this debt mature and have to be replaced with newly issued debt to keep the government running. Increasingly, this newly issued debt is carrying higher interest rates than the debt that is maturing. These new higher interest rates will increase the federal government deficit and accumulated debt, which in turn needs to be serviced with increasing new issuances of more debt. This scenario is much like the dog chasing its tail, but never catching it. Eventually, the government will need to increase taxes, reduce spending or both to put a stop to this cascading of debt. (Unfortunately, our elected officials of both political parties have not made this a priority for many years.)

Interest Rates Impact on Bond and Stock Markets

As discussed above, interest rates and existing bond prices have an inverse relationship. In other words, as interest rates rise, bonds that have already been issued see their market values decline. This has been evident in our clients’ bond portfolios. The good news is that as bonds mature, they are reinvested at today’s higher interest rates. We tend to have a shorter than average maturity portfolio for our clients’ bond portfolios, which means the pick-up in returns will begin to be felt in the relatively near future, assuming interest rate increases slow down and eventually level off. It should also be noted that shorter maturity bonds experience a smaller price decline than longer maturity bonds for an equal rise in interest rates.

Higher interest rates, without a corresponding increase in the growth of an economy, can have unfavorable effects on stock market returns. Most obviously, stocks and bonds compete for a finite pool of investment dollars. When interest rates are higher, this will attract more investment capital to bonds, since the perceived return/risk trade-off improves. When this happens, stock prices will tend to decline, or at least rise more slowly, as a lower stock price will be necessary to restore the perceived return/risk trade-off for a potential investor.

For those of you who might remember something called the “Capital Asset Pricing Model” (CAPM) from college finance classes, you might remember that asset prices are assumed to represent the net present value of all future cash flows to the owner of the asset. One of the inputs into the CAPM is the discounting of future cash flows to the present using an appropriate discount interest rate. In this context, the higher the interest rate, the greater the discounting of the future cash flows to the present value, which translates into a lower price today for the asset in question. This is another way of saying that higher interest rates will put downward pressure on stock prices, absent other factors.

Implications of Current Conditions on Investment Strategy

One should not conclude from this commentary that we feel investors need to panic and exit either their stock or bond investments. While there will always be short-term market fluctuations, we are still optimistic about investment returns over the long-term, although current conditions could provide some constraints on returns when compared to the past decade.

Even as consumers may need to adjust to higher loan payments due to rising interest rates, they are starting from a multi-decade low in terms of how much of their income is currently consumed by debt payments. Corporate balance sheets are similarly positioned with abundant levels of cash when viewed at the macro level. These relatively low starting points for debt service obligations should help prevent any major declines in economic activity. Corporate profit margins are also near all-time high levels.

While today’s stock market valuations, as measured by Price/Earnings ratios, are higher than average levels, subsequent returns over following five-year periods have almost always been positive during the past 25-years of historical data. While rising interest rates tend to lower the ceiling on subsequent stock market returns, negative returns over an ensuing 2-year period are not likely when the 10-year Treasury yield starts out below an interest rate of approximately 5.00%. As a reminder, today’s 10-year Treasury rate is only approximately 3.25%.

We remain firmly committed at this time to maintaining our clients’ investment allocations at their long-term strategic levels, which were determined to be optimal from their own financial plans. Granted, the current market conditions may limit future near-term returns to levels below historical norms. We still think it is better to adjust our collective portfolio return expectations than the holdings within our portfolios. We remain convinced that this strategy produces the highest probability of favorable long-term results for investors.

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Please feel free to contact us with any questions about interest rates, market volatility, your investment portfolio, or the impact of any of the above on your financial plan. The good news is that the impact on your long-term financial plan is likely much less than you fear. We would welcome the opportunity to address any of your questions or concerns.

Kevin Ervin, CFP®, CPA
Senior Financial Planner & Managing Partner


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