Should you be concerned about rising interest rates?

Market Recap

Stocks have been off to a rocky start in 2021 due to a faster than expected rise in US interest rates. Volatility picked up last week with major intraday swings in the Dow Jones, S&P 500, and Nasdaq Composite. 

Last week, the S&P 500 saw over a 4% swing from peak to trough and finished up 0.8% for the week. The tech-heavy Nasdaq saw a 9% swing and finished the week down 2.1%, posting its third consecutive week losing ground. The index is down 8.3% from its February 12 high. The Dow Jones Industrial Average saw over a 3% swing and finished the week up 1.8% for the week.

The yield on the 10-year US Treasury note rose this week to 1.551%, the highest since February 2020. Yields, which rise as bond prices fall, have rallied in response to expectations of a quickening pace of economic growth and inflation as the economy reopens from the COVID-19 pandemic. Federal Reserve Chairman Jerome Powell provided no sign the central bank would seek to stem the rise when he spoke on Thursday and hinted that the US could see a spike in near term inflation, which spooked markets even further.

The past week has seen a classic rotation from growth to value as advances by energy, financials, and industrials offset declines in technology and consumer discretionary sectors. This rotation does not necessarily mean that investors should ditch their technology/growth stocks and run for value. Growth stocks have outperformed value stocks for the last ten plus years and there are reasons to believe that trend continues as the digital evolution has been forced upon us quicker than many expected. While we are still overweight technology, we do believe there is a place for value and cyclical sectors (industrials, energy, financials) in portfolios as we believe the outperformance of growth versus value will not be as dramatic as we have seen in the past. 

On the face of things, the recent spike in interest rates may seem alarming; however, we must focus on why interest rates are rising. The answer to this question is because economic growth is strong and could be on the cusp of one of the strongest economic recoveries in history, indicating that the economy can support marginally higher interest rates.

Interest rates have been caught in a 35 year downtrend and we believe that rates will continue to be bound to this range until the Federal Reserve eases up on its bond buying program, which is not expected to occur until 2023. While we do not believe that rates will go negative, we do believe that the acceleration in the rise of interest rates will slow and the US 10-year will level out over the coming weeks.

What happens to bond ETFs when interest rates rise?

According to Vanguard, bonds are issued by governments and corporations when they want to raise money. By buying a bond, you are giving the issuer (typically a government or corporation) a loan, they agree to pay you back the face value of the loan on a specific date, and to pay you periodic interest payments along the way, usually twice a year. Unlike stocks, bonds issued by companies give you no ownership rights. So you don't necessarily benefit from the company's growth, but you won't see as much impact when the company isn't doing as well, either—as long as it still has the resources to stay current on its loans.

Bonds, then, give you 2 potential benefits when you hold them as part of your portfolio: They give you a stream of income, and they are meant to offset some of the volatility you might see from owning stocks. However, in the recent market corrections in 2020 and 2021, investors have been selling all assets including bonds, stocks, and gold to raise dollars given the extreme uncertainty tied to the COVID-19 pandemic. Traditional safe haven assets were not doing their job when it comes to preserving capital and investors fled to the most stable asset in the world—US Dollars.

Bonds have two kinds of risks associated with them—credit risk and interest rate risk. 

Credit risk, also known as default risk, is the risk that a bond issuer will default on their payments of interest and principal. When a bond issuer defaults on their payments, the holders of the bond may lose most of their principal.

Interest rate risk is the potential that a change in overall interest rates will reduce the value of a bond or other fixed-rate investment. Bond prices and interest rates have an inverse relationship. When interest rates fall, bond prices go up. When interest rates rise, bond prices fall. 

Bond ETFs have interest rate risk as well. History tells us that when interest rates rise, the price of bond ETFs should fall because the underlying bonds that the ETFs hold have lost value, thus resulting in a drop in bond ETFs’ price. Below is a chart showing the relationship between interest rates and the price of one of the largest bond ETFs—iShares US Aggregate Bond (AGG)

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter (article), will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.

Economic growth is hot, expected to be white hot

Jobs coming back in reopening sectors

The February 2021 jobs report blew past expectations thanks to a sharp rebound in leisure and hospitality, signaling the labor market is expecting an economic boom in the sectors that have been forced to shut down for nearly a year due to COVID-19 lockdowns. 

The Labor Department reported Friday that payrolls rose by 379,000 versus expectations of 210,000 in February. The unemployment rate edged down to 6.2%.

Confidence beginning to increase as vaccines become widely administered

Pent-up demand is real. People are tired of working from home, lack of social interaction, and lack of travel/entertainment. As the US is on the cusp of vaccinating 3 million people per day, consumer confidence is following this upward trend. As more individuals get vaccinated across the globe everyday, we have seen an uptick in airline bookings, leisure and hospitality hiring, and hotel bookings confirming analysts expectations of a strong desire to travel when the pandemic ends.

On February 22, 2021 Deloitte released a survey of Consumer perception of travel safety as vaccines rollout. The findings were extremely positive for the leisure and entertainment industry.

Key takeaways from the survey:

  • As a result of the vaccine rollout, the percentage of US adults feeling safe staying in a hotel reached 46% and flying reached 34% - their highest levels since April 2020.
  • Of those already vaccinated, 70% feel safe staying in a hotel and 54% feel safe flying.
  • More than half (53%) of those already vaccinated are likely to spend more on travel in the next four weeks.

GDP estimates and a well positioned consumer

The US economy has roared back to life in 2021, with first-quarter growth set to defy even the highest expectations as another fresh influx of stimulus has just been passed.

Manufacturing data Monday showed the sector at its highest growth level since August 2018. That report from the Institute for Supply Management in turn helped confirm the notion among economists that output to start the year is far better than the low single-digit growth many had been predicting in late 2020.

The Atlanta Federal Reserve, which tracks data in real time to estimate changes in gross domestic product, now is indicating a 10% gain for the first three months of the year. Goldman Sachs upgraded its outlook for the US economy in 2021 on Tuesday and says it now expects a larger coronavirus relief package. Economists at the bank raised their forecast for 2021 US gross-domestic-product growth to 6.8% from 6.6% and to 4.5% from 4.3% in 2022.

That comes on the heels of a report Friday showing that personal income surged 10% in January, thanks largely to $600 stimulus checks from the government. Household wealth increased nearly $2 trillion for the month while spending rose just 2.4%, or $340.9 billion.

It should be noted that a headwind to high GDP estimates is that the economy recovers slower than these expectations which would cause equities to sell-off. Economic data will need to be paid close attention to as we gain more clarity into the economic recovery.

Senate passes $1.9 trillion COVID relief package

The Senate approved the package along party lines, 50-49, after deliberating all of Friday and into Saturday morning. The package now heads back to the House, which must approve the Senate-revised legislation before sending it to the White House for Mr. Biden’s signature. The House is expected to take up the measure on Tuesday.

The legislation would provide $300 in weekly unemployment benefits through Sept. 6, send $1,400 direct payments to many Americans, direct $350 billion to state and local governments, fund vaccine distribution, and expand the child tax credit, among other aid. 

This giant stimulus deal should be the wind in the sails to get the economy back on track.

Market Outlook

As a continuation to our research/investing thesis of “seeking opportunities in business cycles”, we believe we are still early to early/mid-cycle and outline opportunities according to the current business cycle below.

While we believe that the rise in interest rates will slow over the coming weeks, we do expect volatility to continue as the economy opens back up and we have more clarity on the participation of the consumer in the economic recovery and the speed in which GDP bounces back.

We also believe that the rotation from technology to cyclicals, more specifically to industrials and energy, will continue; however, we believe that the bulk of this rotation has already occurred. We believe that many of the large to mega-cap technology names are flashing signals of being oversold and could potentially see some dip-buying in these names. We believe that there will continue to be valuation/multiple pressure on stocks with extremely high price to earnings that are “pre-revenue” or with negative/little earnings. 

We believe that long-term investors should raise cash by selling bond ETFs on any subsequent drop in interest rates to buy cyclical stocks. The inverse relationship of bond prices and interest rates is called interest rate risk. When interest rates fall, bond prices go up. When interest rates rise, bond prices fall. Bond ETFs have interest rate risk as well. When interest rates rise, the price of bond ETFs should fall because the underlying bonds that the ETFs hold have lost value, thus resulting in a drop in bond ETFs’ price.

We also believe that inflation is real and will increase in the future. For investors that have a focus on only gold; however, we would recommend that they rotate from single metal exposure and purchase a diversified mix of commodities via ETF as prices are beginning to rise in lumber, soft commodities, hard commodities, and energy. We believe that this trend in rising commodity prices, which will eventually lead to inflation, continues for the remainder of 2021 and possibly into 2022.

Typically during the early cycle, small-cap equities outperform and we remain overweight to small-caps especially given the potential for rising rates, additional stimulus, and broader economic recovery.

Along with rising inflation, commodity prices, global production, and government debt levels, emerging market equities--especially in China--should continue to perform strongly. China posted the only positive GDP in 2020 and is expected to grow at 6% for 2021.

While we do not see much benefit in diversifying into bonds given the current environment, we do believe that long-term portfolios should mainly be comprised of equities and should have core and tactical components. Core components should comprise of the S&P 500, Dow Jones, Nasdaq 100, and commodities. Tactical equity components should comprise of emerging market, small-caps, industrials, energy, travel and leisure, and a small allocation to electric vehicle technology.

At some point in the future, the increase in the money supply along with astronomical government debt levels due to massive monetary stimulus will have to be addressed in the not so distant future. There are three ways to reduce debt - default, restructure, or inflation. Typically the path of least resistance to reduce debt is inflation. 

Below is a chart of our opinion on asset class/sector weightings throughout the business cycle:

Disclosure: The views expressed in this chart are purely opinions and should not be construed as investment advice or a recommendation for any investment strategy or particular product/investment. The opinions expressed are those of the author and are based on current market conditions and are subject to change without notice. Investors must take into account their particular time horizons and risk tolerance. Past performance is not indicative of future results. All investments involve risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter (article), will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Always consult a professional and carefully consider the investment objectives, risks, charges and expenses and consider their personal investment goals/objectives, time horizon, and risk tolerance before investing.

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