The Fed is at it again. Just this week, the central bank’s Chair Janet Yellen and company added new clouds to the interest rate horizon, announcing that a cooling economy means that rates will stay at their current low levels for the time being.
Everyone from the media to the markets is engaged in a level of “Fed-watching” that is unprecedented in recent times – and for good reason. In fact, an examination of nearly a half-century of market returns reveals that the fixation on Fed monetary policy is well founded, and investors ignore Fed actions at their own peril. Here are five things investors should know about the Fed and the prospects of interest rate moves in the future:
Rising Interest Rates Are Bad news for the stock market
Some pundits want to put a pretty face on rising interest rates by suggesting this shows the Fed is confident with economic growth prospects. But if you’re an investor – watch out! Rising interest rates have been simply bad news for long-term market returns. In fact, in periods when the Fed has been lowering rates, the S&P 500 earned an annualized return of 15% versus about 6% during periods when the Fed has been raising rates.
Bonds perform similarly whether Interest rates are rising or falling
While stocks perform dramatically better when the Fed is lowering rates, the evidence on bonds is substantially different. U.S. Treasury and U.S. government agency bonds have roughly the same returns whether rates are rising or falling. Even more interesting: the highest returns for these segments of the bond market happen when changes in rates are inconsistent.
On the other hand, highly rated corporate bonds and junk bonds follow much the same pattern as stocks – lower when the Fed is raising rates than when the Fed is loosening them. Investors don’t get much diversification benefit with respect to Fed monetary policy by adding corporate bonds or junk bonds to their stock portfolios.
Don’t count on international markets to save you
Investors may be tempted to trade their U.S. stocks for international stocks when the Fed raises rates. Surely foreign markets should offer better returns when the Fed is raising interest rates and slowing money supply growth – right?
Unfortunately, with regard to Fed policy, most global markets don’t zig when the U.S. market zags. The returns to global developed markets follow virtually the same pattern with respect to monetary policy as the U.S. markets. Based on historical market performance in Europe, Australia, Asia and the Far East, a U.S.-based investor would have gained very little from investing in a broadly diversified portfolio of foreign stocks when the Fed is bumping rates up.
That isn’t to say that some foreign markets haven’t prospered when rates are rising. Emerging markets and frontier markets actually realized a much higher return during these periods.
Now, it’s usually very difficult for U.S. investors to muster up the nerve and take the plunge into emerging markets when prospects for the U.S. and developed markets are darkening. But a little intestinal fortitude can go a long way. Investors would be well served to remember billionaire investor Warren Buffett’s mantra to “Be greedy when others are fearful and fearful when others are greedy.”
Some sectors are better than others
While most stock market sectors follow the same pattern as the broad stock market – that is, highest returns during times when the Fed is keeping interest rates low – there are some sectors that buck the trend and do relatively well when the Fed tightens its reins. Sectors that are less sensitive to disposable income levels – specifically, consumer goods, food, utilities and energy – hold their own when the Fed becomes a monetary Grinch. Investors are well served to avoid sectors that rely heavily on discretionary spending (like autos, consumer durables, business equipment, retail and construction) during times when rates are higher.
The bottom line: some form of sector rotation with respect to Fed policy will help investors improve their investment performance, in contrast with a straight “buy and hold” approach. A smart place to get started can be through sector ETFs. These can be used in a cost effective way to capitalize on the Fed-stock sector relationship.
Commodities prefer rising rates
The “most interesting man in the world” prefers Dos Equis and commodities prefer rising interest rates. Returns to commodities prosper when the money supply is constrained and languish when the economy is swimming in cash. An index composed of 24 commodities from all commodity sectors – energy products, industrial metals, agricultural products, livestock products and precious metals – returned over 17.5% when rates were rising. During periods when rates were going the opposite way, it actually fell by 0.19%.
But contrary to conventional wisdom, gold is no safe haven. Many investment professionals tout gold as a good inflation hedge and solid performer in bad times. Our research shows that gold actually performs more poorly during higher interest rate periods than lower rates ones. In fact, after adjusting for inflation gold doesn’t even earn a positive return when rates are rising.
To sum things up: all those Fed watchers out there aren’t crazy. The Fed has a serious and measurable impact on investment performance across virtually every asset class. So pay attention to the Fed – your wallet will thank you for it.
Robert R. Johnson is president and CEO of the American College of Financial Services and co-author of the recent McGraw-Hill book, Invest With The Fed, with Northern Illinois University Professor Gerald R. Jensen and Florida Atlantic Professor Luis Garcia-Feijoo.