Interest rates are finally moving higher. After leaving rates unchanged from 2008 to 2015, the Fed’s Open Markets Committee (FOMC) has used its December meeting to raise short-term rates for two years in a row. From a low range of 0% – 0.25%, the Fed funds target now sits at 0.5% – 0.75%. This latest move was widely expected, as the majority of economic data released over the past few months has been positive.
There’s little doubt that Fed officials would like to see rates move much higher. More than two years ago, it released a policy normalization plan that calls for rates to be increased very gradually (in 0.25% increments) – from near-zero to 3% over the next several years. A year ago, the FOMC “decided that economic conditions and the economic outlook warranted the commencement of the policy normalization process” and raised rates for the first time since December 2008. “Gradually” meant within the next two to three years according to the Fed’s economic forecasts released at that time, with four rate increases expected in 2016. Since then, lower-than-expected domestic growth, anemic global growth and the pursuit of negative interest rate policies by central banks in much of the developed world prevented Fed officials from raising rates again until now. However, with recent data showing increased optimism for stronger economic growth, Fed officials see an opportunity to “catch up”. For 2017, the majority of Fed officials now see at least three rate increases (up from two) and expect to end the year with rates between 1.25% – 1.5%.
What will higher interest rates mean for consumers? Higher rates mean higher financing costs, so sales of big-ticket items like houses and automobiles could see a modest decline. For investors, the impact will be mixed. Rising rates mean higher coupons on new bonds, but the value of existing bonds in a portfolio will lose a small portion of their value – which is only a problem if selling prior to maturity. Some parts of the equity market – particularly for banks- should enjoy higher profit margins as rates increase. Other parts, such as insurance and real estate stocks, will have their profit margins squeezed.
Predicting the ‘timing’ of interest rate hikes, inflation and the like is a fool’s game. One doesn’t have to look very hard to find a cornucopia of failed attempts that illustrate this point. However, we believe that it’s possible to at least position one’s portfolio for a rising interest rate ‘trend’. When the Fed tells markets to expect higher interest rates in the future the unofficial investing “playbook” calls for shortening portfolio duration and reducing exposure to stocks negatively impacted by rising interest rates. So it’s certainly no accident that our Trust Investment Committee made the decision to incorporate fixed income investment vehicles offering durations shorter than the Bloomberg Barclays U.S. Aggregate Bond Index into client accounts. Likewise, our Dividend Growth portfolio strategy has largely avoided stocks that will be negatively impacted by rising interest rates. By focusing on trending rather than timing, we’ve been able to reduce the short-term volatility that occurs when the unexpected happens (i.e. Brexit, U.S. presidential election, etc.) and causes investors to react emotionally.
After beginning the year with the worst stock market performance since 2008 then seeing rates on U.S. Treasuries reach historical lows in July, investor expectations for full year returns were tepid at best. As the financial markets have done countless times over the years, returns failed to match broad expectations. Markets are on pace to end the year with surprisingly strong returns while domestic economic growth is accelerating. What does 2017 have in store? The only guarantee is for more surprises. That’s why it’s important to make sure that your financial plan is adjusting to what you have in store for 2017 and beyond. As Eisenhower once said, “plans are nothing, planning is everything.”
The start of the new year is a wonderful time to contact your advisor to review your investment profile and objectives and discuss how possible changes to the tax code might impact your investments. We appreciate the confidence you’ve placed in us and wish you a happy and prosperous 2017!