Are your investments at risk?
It’s common knowledge what’s happening when interest rates go up. Higher interest rates instantly provide better returns for short-term investors. However, investors seeking capital appreciation and income through longer-dated bonds are affected negatively during such a cycle. Also, the cost of doing business for enterprises is quite likely to become more expensive; ultimately this affects the price of day-to-day products, as businesses tend to borrow to fund their business and growth.
Central bankers have different tools to manage the monetary-policy e.g. open-market operations. Through this tool, a central bank can adjust the quantity of reserves in the banking system and through this can keep the reference rate around the target interest rate level that was decided by the committee. This rate is then used by banks to lend to each other overnight.
What’s new this time?
After QE3 the Fed’s balance sheet is very different to its position prior the financial crisis. In fact, it’s gone from USD 800 billion to USD 4.5 trillion! So the central bank has a delicate job to do now. Because if interest rates are increased too quickly and too much at once, it will unravel everything it’s tried to achieve during the past 6 years. Ideally, the Fed should raise interest rates without destabilizing other items, i.e. reducing the level of securities it holds, without reducing the level of reserves held by commercial banks.
We’re fairly convinced that the Fed can achieve its goals and objectives. While it can decide on its own on how much securities it’s willing to maintain on its books, it can also provide sufficient motivation to the market (i.e. commercial banks) to maintain the level of reserves required to achieve its objectives. Currently, the Fed pays 0.25% to banks that deposit money with the central bank. By raising this rate to 0.5% it will achieve one goal, i.e. commercial banks will continue to maintain, or even increase the level of reserves. But ultimately, commercial banks are not supposed to deposit money with the central bank but rather lend it to the greater economy so that the economy prospers.
By increasing interest rates, the central bank is entering into a new area and it may well end-up producing a counter effect, i.e. the economy could run into a recession much earlier than expected. The general consensus is that this might occur in 2017 in the US market; however, we believe that the US economy could show important signs of fatigue as early as the 4th quarter of 2016.
So, what does this mean for equity investors! The short answer is, about one more quarter of good performance can be expected. The remainder of 2016 will be lackluster and most likely negative.