One of the points I tried to stress in my book was that each economic cycle is its own unique environment. I find it very helpful to think of the financial system as a constantly evolving system. Although the past can serve as general guide, it will never serve as a perfect guide. And that’s part of what makes our new world of exorbitant data and backtesting so dangerous – we’ve turned into a group of investors who rely on extrapolative expectations suffering from excessive recency bias. It’s gotten so bad that people engaged in this sort of backtesting don’t even think they’re predicting the future implicitly. It’s madness.
This is happening left and right now with what looks like an interest rate hike. I have read two dozen research notes and blog posts about how to prepare a portfolio for an interest rate hike. And yet all of these reports are based on small and mostly useless data sets from the last 40 years. To be clear, there is only ONE environment in the past that even remotely resembles what the current environment looks like. And that’s the 1940’s when rates were low and rising following a substantial deleveraging and a financial crisis. I would argue that there isn’t a single other environment in US history that will help us decipher this environment.
In the 1940’s interest rates bottomed at about 2% and slowly doubled over the next 20 years. Not surprisingly, bonds generated very low returns that barely surpassed 2% on average. Stocks did much better however and averaged 15% returns in that 20 year period. Unfortunately, one piece of data is hardly enough to even consider as credible. So that leaves us with nothing more than some general projections based on what we know.
So, what do we know?
1. We know that bond investors who are looking to generate a positive real return in the next 30 years probably have to be strategic. The math is simply too, well, simple. If you buy a 30 year bond today you will get back the principal plus about 3% per year. As I’ve stated on many occasions, the fixed income markets have forced many yield chasing asset allocators to become short-term and strategic. Otherwise, they are destined to low returns. This is one reason why I’ve noted the importance of recent discrepancies in fixed income markets such as the unsustainable belief that permanent deflation was coming to Europe and US bonds heading into 2015. Some strategic thinking here and there can help you avoid environments like the bond debacle that is unfolding in 2015. But more importantly, these bond holders have to recognize that returns are just going to be low for a long time.
2. Rising interest rates are potentially bad for bonds in the short-term, but aren’t necessarily bad in the long-term. Again, this is just simple math. A T-Note investor who owns a 10 year note at 2.3% will suffer a short-term loss of 11.5% if interest rates rise to 4% next year, but that same note holder will not lose a single dime if they hold until maturity. So, you have to understand how your fixed income duration risk relates to your personal risk profile. Bonds serve as an important asset in any diversified portfolio because they hedge equity market risk. The fact that they will generate low returns does not mean they can’t still achieve that goal.
3. Interest rate hikes are not bad for stocks. We don’t need math or history to understand this. We just need to understand why rates are usually hiked. In general, a Central Bank hikes rates because the economy is doing well. This usually occurs because inflation is rising due to higher wages and stronger growth. So, the Central Bank is trying to get ahead of what looks like a potential runaway train. Central Banks aren’t trying to suffocate growth when they raise rates. They are usually just trying to temper it a bit so it doesn’t get out of control. But it’s pretty safe to say that a rate hike is usually a POSITIVE sign of rising output, wages, inflation, etc. And this usually coincides with improving stock market conditions. Yes, markets can get fidgety around rate hike time because they try to be forward looking and assume that this means that growth might be a bit lower going forward, but that’s just typical late cycle action. Fed rate hikes aren’t intended to crush economic growth, corporate profits or bull markets and they usually don’t.
The bottom line is, the past won’t tell us much about this rate hike cycle, but a little common sense and forward thinking tells us that it’s unlikely to be a good reason to go jump in your bomb bunker or make life altering portfolio shifts.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.