Rising Interest Rates Will Be Good For Stocks

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Investors continue to be concerned about two key issues for the stock market: (i) how stocks will react as interest rates rise and (ii) the impact of U.S. dollar strength relative to other currencies and its potential effect on the earnings outlook for companies with currency exposure.

The lack of an alternative to equities or "TINA" (there is no alternative)is directly related to the historically low interest rate environment we are currently experiencing, and the fact that the broader fixed income asset class is unappealing to investors. Many stocks actually have higher dividend yields than bonds, and these dividends have grown (and may further increase) over time. This market dynamic maintains equities as the preferred vehicle to generate investment returns.

From the current level of a 2% ten-year U.S. Treasury, it's safe to assume that interest rates will be higher rather than lower in the coming years. The big questions are when interest rates will increase, and the impact an increase will have on equity markets. The Federal Reserve recently removed the word "patient" from the official Fed statement, but Federal Reserve Chair Yellen was very careful to say that the U.S. economy is currently in a "soft patch", and that rates would take longer to rise than originally forecasted. On March 18th, the day of the Fed statement and press conference, markets reversed earlier losses and reacted favorably to this news by adding over 1% to the Dow Jones Industrial Index and the S&P 500®.

The last time the Federal Reserve raised interest rates was prior to the global financial crisis in June 2006. The impact on the Russell 2000® and the S&P 500® in the third and fourth quarters of 2006 was surprising to many, as the Russell 2000® rose 0.44% and 8.90%, and the S&P 500® gained 5.67% and 6.70%, respectively, during each of those periods. Full year 2006 returns for the Russell 2000® and S&P 500® were 18.37% and 15.79%, respectively. Nine years have passed since the last rate increase and many professional and individual bond investors have not seen a significant price decline in their holdings during this period of time. By contrast, professional and individual equity investors have experienced the financial crisis, the Greek debt crisis and other events that resulted in a bear market for stocks and a recovery period that was volatile and uneven. When interest rates do rise for a sustainable period of time and investors are faced with a bear market for bonds, it will be interesting to see how bond portfolio managers and individual investors adjust to the changing rate landscape.

The impact of rising rates on equities can be varied, but in the current environment we believe that higher rates will be a positive for several reasons: first, financials, notably banks, have not yet participated in the rally. This is important, as financials are a major component of equity benchmarks. We believe that rising interest rates are a positive for these companies given the opportunity for banks to increase profits as the net interest margin and money velocity outlook improves. Second, higher rates should coincide with an improving U.S. economy, which reinforces our positive outlook for revenue and earnings growth. All of this is occurring while energy prices are soft in the U.S and around the globe. Lower oil prices, which should be stimulative for the economy, have not been low for a sufficient period of time to positively impact the economy. The effect of lower oil prices may also provide a partial offset to the dampening impact from higher interest rates.

While we remain positive on growth in the U.S., our view is somewhat relative, as we do not see GDP growth above 3.5%. Historically this is the environment that has favored small cap stocks relative to large cap stocks.

The strong dollar also impacts the U.S. market and influences asset allocation decisions within equity asset classes. Generally speaking, during periods of dollar strength, U.S. equities tend to perform well as a result of capital flowing into the U.S. Since 1979, small cap stocks have outperformed large caps 70% of the time and have outperformed by more than 300 basis points when the dollar is rising. Since small caps, represented by the Russell 2000®, have only 20% exposure to non-U.S. markets (in terms of foreign sales) compared to 30% exposure for companies represented in the S&P 500®, currency has significantly less of an impact to earnings of small cap companies than it does to those of large cap companies.

In the fall of 2014, the S&P 500® and the Russell 2000®, as well as other equity indices, experienced a sharp and sudden correction tied to sharply declining energy prices and fear of a weak upcoming earnings season. The S&P 500® recent mini-bottom occurred on October 15, 2014 at 1,862.49 and the Russell 2000® mini-bottom occurred on October 13, 2014 at 1,049.30. At roughly the same time, in late September 2014, the euro/dollar exchange rate was 1.28. As of April 1, 2015, the dollar has dropped to 107.63 while the S&P 500® and the Russell 2000® have risen to 2,059.69 and 1,251.71, respectively. From a percentage return basis, the S&P 500® has risen by 10.6% and the Russell 2000® has risen by 19.3%, totaling approximately 870 basis points of outperformance during this period of dollar strength.

Clearly, currency has a significant impact on those companies that derive revenue from outside the U.S. Multinationals tend to be most negatively impacted by a strong dollar as their exports become less competitive and their earnings from operations outside the U.S. are translated to fewer dollars. This headwind could be an additional catalyst for merger activity of big companies acquiring smaller companies to offset organic growth concerns. In summary, we expect that rising U.S. interest rates and dollar strength should contribute to small cap stock outperformance over the S&P 500® for the foreseeable future.

 

Dan Veru is Chief Investment Officer at Palisade Capital Management.  

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