The Stock Market Prepares for Higher Interest Rates

U.S. stocks have been stuck in a trading range since the middle of July. Q3 earnings and central bank policy are likely to be the factors driving near-term market direction but any number of wildcard events could derail a rally attempt. The market is currently priced for perfection but that does not mean it can’t go higher. In 10 years is it likely to be significantly higher.

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Q3 earnings expectations are not very high. Market consensus currently suggest this will be the sixth straight quarter of earnings declines. An earnings contraction of this duration has never happened before without a market correction. It is possible the two swift stock market sell-offs and recoveries over the last 12 months were all that was needed but the earnings picture has not improved suggesting a repeat is likely.

Talk of a Fed rate hike later this year (after the election) has pressured bond prices as well as gold. After a very strong rally earlier this year gold has corrected over 8%. Real estate and utilities have also been hit by potential rate hikes.

European stocks are starting to waver again but Asia and Latin America regions have been able to maintain the uptrends they started around the start of the year.

On the bond side of the market, the biggest surprise might be how well corporate junk bonds have held up. The recovery in crude oil prices appears to have taken some of the pressure off the highly leveraged energy market.

We have definitely seen a change in market character as we transitioned from summer to fall. To give you an idea here is how some asset classes have performed over the last 90 days.

90dayAssetClassPerf

The market appears to be telling us interest rates are going to adjust up which has caused most bonds, gold and real estate to fall after being darlings earlier this year, especially gold and real estate.

Money is still being put to work in high-growth stocks and markets which explains why the Nasdaq 100 and most emerging markets are outperforming developed market large-cap stocks. Also, in Europe and Japan central bank policy remains more active (although Japan has stepped back a bit), where stocks are still responding favorably.

What we are experiencing is a classic adjustment period where markets are taking into consideration the impact of higher interest rates on the short end of the yield curve and the potential impact to longer bond maturities.

Exposure to high-growth mid-large cap U.S. and emerging markets stocks has helped maintain portfolio value over the last few months. So far shorter maturity bonds have only experienced small declines but further weakness might indicate a market that expects the economic recovery to accelerate with more rate hikes to follow. Don’t count on it, there is sparse data suggesting anything of the sort.

As I have said before, margin debt is the one area where higher rates could aggravate stocks. Margin debt peaked 18 months ago so it is entirely possible the next ramp up on stock prices will be a function of levering up again assuming the costs are not prohibitive – we are likely a long way from that problem. Who really thinks 3-month T-bill rates will normalize at 2.6% anytime soon?

There are plenty of strategies for positioning your retirement assets in this market for long-term growth or a margin of safety. Let me know if this is a subject you would like to discuss in more detail.

Posted in Interest Rates, Investments and tagged , , , .

Brian Dightman