Digesting the Implications of Higher Rates

Weekly Commentary Overview

Stocks climbed higher last week, with investors exhibiting a mixed reaction to a sharp rise in both nominal and real (i.e., after-inflation) U.S. interest rates.
There are several factors inhibiting further gains: high valuations, a dearth of top-line growth and most recently, a noticeable deterioration in credit quality.
The shift in the credit regime has implications for stocks. Namely, we continue to favor a tilt toward quality.
A decent U.S. economy, along with some evidence of stabilization in international markets, has pushed the odds of a December interest rate hike by the Federal Reserve higher.
As a result, real U.S. rates are climbing. Meanwhile, the opposite is occurring in large parts of Europe and Japan.
This divergence helps explain the renewed strength in the U.S. dollar, which last week reached its highest level since the spring. The combination of a strong dollar and rising real rates is also having a predictable effect on precious metals prices.
We continue to like international developed markets, but given our expectations for further dollar appreciation, we believe investors should use vehicles that hedge most or all of their international currency exposure.

Stocks Climb Against a Backdrop of Higher Rates

Stocks climbed higher last week, with investors exhibiting a mixed reaction to a sharp rise in both nominal and real (i.e., after-inflation) U.S. interest rates. The tech-heavy Nasdaq Composite Index fared best, adding 1.86% to close the week at 5,147, while the Dow Jones Industrial Average rose 1.39% to 17,910 and the S&P 500 Index advanced 0.96% to 2,099. Meanwhile, the yield on the 10-year Treasury climbed from 2.15% to 2.33%, as its price fell. Two-year Treasuries followed a similar path.

We expect the rise in long-term rates in the U.S. to be contained. But the fact that U.S. rates, both long- and short-term, are rising while rates are falling in much of the rest of the world has a number of implications. Among them, it suggests the dollar will continue to strengthen, keeping pressure on precious metals, and supports the case for hedging currency exposure in international stocks.

Equities Keep a Quality Focus

Last week, stocks benefited from a strong report from the services sector along with the announcement of more mergers and acquisitions. That said, there are several factors inhibiting further gains: high valuations, a dearth of top-line growth and most recently, a noticeable deterioration in credit quality.

U.S. corporate defaults recently hit a four-year high. Moreover, defaults of speculative-grade bonds (those rated lower than Baa) climbed to 2.5% from 2.1% in the third quarter. That is still modest by historical standards, but credit ratings agency Moody's expects defaults to rise further, to 3.8% by next October.

The shift in the credit regime has implications for stocks. Namely, we continue to favor a tilt toward quality—that is, companies with a high return-on-equity, low earnings variability and modest financial leverage. Over the past three months, this approach has outperformed a focus on momentum names, companies with rapid price appreciation. While momentum has been an effective style over the past several years as markets generally marched upward, it has struggled since volatility began to rise in the late summer.

We expect the rise in long-term rates in the U.S. to be contained. But the fact that U.S. rates, both long- and short-term, are rising while rates are falling in much of the rest of the world has a number of implications.

Higher Short-Term Yields: Good for the Dollar, Bad for Gold

Last week provided more evidence that it is increasingly difficult to characterize the state of the economy with a single number. For example, the manufacturing sector is struggling, as seen by October’s ISM Manufacturing Survey, which fell to 50.1, the lowest level since the spring of 2013 and barely above contraction territory. However, the services sector continues to demonstrate resilience, while the U.S. labor market is experiencing renewed strength. The economy created roughly 270,000 net new jobs in October, pushing up hourly wages in the process.

The data may be mixed, but still point to a decent U.S. economy. That, along with some evidence of stabilization in international markets, has pushed the odds of a December interest rate hike by the Federal Reserve higher. As a result, real U.S. rates are climbing. Meanwhile, the opposite is occurring in large parts of Europe and Japan.

Over the past six weeks, rates have declined in Germany, Italy and Japan. Several factors, including demographics and institutional demand for long-term, high-quality bonds, will help contain the rise in long-term U.S. interest rates, but we will likely continue to see a divergence between U.S. and international short-term rates.

This divergence helps explain the renewed strength in the U.S. dollar, which last week reached its highest level since the spring. The combination of a strong dollar and rising real rates is also having a predictable effect on precious metals prices. The simultaneous rise in real and nominal rates reflects the fact that inflation is contained, and that puts downward pressure on the price of precious metals (since they are viewed as an inflation hedge, but provide no income, they consequently become less attractive). This time is no different, with gold and silver trading back down toward their summer lows, below $1,100/ounce for gold.

Bottom line: We remain cautious on precious metals. Still, having a hedge against inflation in a portfolio is a sound strategy, and we prefer Treasury Inflation Protected Securities in that role.

But a stronger dollar has other implications. Most notably, it can erode the local gains made in international stocks. However, we continue to like international developed markets, such as Europe and Japan. Given our expectations for further dollar appreciation, we believe investors should use vehicles that hedge most or all of their international currency exposure.