blackrock-no-exit

NO EXIT Can the Fed Normalize Rates—And How Will It Impact Stocks?

MAY 2015

MARKE T

PERSPECTIVES

executive summary

Investors have long anticipated the moment when the Federal Reserve (Fed) will increase interest rates—and they are still waiting. The soft tone to U.S. first-quarter economic data coupled with below-target inflation has provided the Federal Reserve with considerable latitude as to when to start raising short-term interest rates. Still, given that the United States is creating jobs at the fastest pace since the late 1990s and the risks that ultralow rates pose to financial stability, it is increasingly difficult to justify a 0% policy rate. As such, while the pace of monetary tightening is likely to be gradual, the Fed should start to remove monetary accommodation later this year. The question then is: What will be the impact of the Fed moves, particularly for equities?

RUSS KOESTERICH Managing Director, BlackRock Chief Investment Strategist

In answering that question, it is important to first note that this will be a very different tightening cycle compared to previous instances. The Federal Funds rate has been at 0% for nearly a decade. After several rounds of quantitative easing, the Fed’s balance sheet stands at approximately $4.5 trillion, more than five times its pre-crisis level. The flip side of a swollen balance sheet is substantial excess reserves in the banking sector. This scenario will require the Fed to adopt a new set of monetary tools, including interest paid on excess reserves (IOER) and reverse repurchase agreements. Given these differences, the equity market’s reaction to tightening is more unpredictable than previous cycles. That said, history does suggest that the switch from ultra-loose monetary accommodation to tightening, albeit gentle tightening, is likely to have an impact.

The start of a tightening cycle typically causes some rise in volatility, but rarely a bear market. The extent of the impact is likely to be influenced by two other conditions: changes in equity valuations and the direction of inflation. The fact that U.S. equity multiples have been rising suggests that markets are at greater risk for at least a modest correction, say, 5% to 10%. One area in particular warrants caution: small caps, which investors have embraced as a way to mitigate the impact of a strong dollar on earnings. Historically, however, small caps have been more sensitive to monetary tightening than large caps.

The good news is that to the extent short-term rates are rising in conjunction with inflation—so real rates are flat—this should mitigate the impact from a Fed lift-off.

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NO EXIT: CAN THE FED NORMALIZE RATES—AND HOW WILL IT IMPACT STOCKS?

“Everyone has his day and some days last longer than others.”

—Winston Churchill

lift-off is not about tightening monetary conditions or squeezing out inflation, but getting back to normal.

The period of ultralow yields has lasted a lot longer than anyone expected. Zero rates were initially envisioned as a drastic but necessary measure to stave off a depression and/ or financial meltdown. However, as it became obvious that the recovery was subpar, zero nominal rates have become a semi-permanent fixture in most developed countries.

In Europe, contrary to most financial theory, zero has not even proved to be the lower bound as policy rates have dipped into negative territory.

Non-farm payrolls are growing at the fastest pace since the late 1990s. Accelerating wage growth, rising household wealth and low gasoline prices should help the economy bounce back in the second quarter. While we’re not looking for a ’90s-style boom, it is increasingly difficult to reconcile the improvement in the U.S. economy and the strength in the labor market with a zero policy rate.

While the stuttering recovery in Europe and the multi-decade stagnation in Japan may necessitate a longer period of zero policy rates in those regions, the United States is different.

Although it is true that many commentators are questioning the wisdom of raising rates given sluggish economic performance in the first quarter and still below-target inflation, to our minds that is the wrong question. An initial

Not only is zero the wrong number, it is arguably a dangerous number. While the Fed’s unorthodox monetary policy may have prevented an even more sluggish recovery, extraordinary monetary stimulus has come at a cost: significant distortions in most asset markets. Six-plus years of zero interest rates have resulted in an evermore desperate stretch for yield, inflating assets around the world. The longer the Fed maintains this policy, the greater the risk of asset bubbles.

B L A C K R O C K [3]

In assessing the impact of lift-off it is worth reiterating just how unusual the current rate environment is. The Fed has engineered several easing cycles over the past 60 years; in none of those previous cycles have rates ever been this low for this long (see Figure 1).

FIGURE 1: U.S. FEDERAL FUNDS RATE 1954 to Present

Since 1955, the Fed Funds rate has averaged roughly 5%.

And while there has obviously been significant deviations from the average, the current cycle is unprecedented. Rates were ultralow in the 1950s and again, albeit briefly, in the early part of the last decade, but neither episode lasted nearly as long as the present cycle.

15

10

5

7/31/12

9/30/07

11/30/02

1/31/98

3/31/93

5/31/88

7/31/83

9/30/78

11/30/73

1/31/69

3/31/64

5/31/59

7/31/54

0

Source: Bloomberg 4/15/15.

NOT YOUR FATHER’S TIGHTENING CYCLE By the end of the year, we expect that investors will be contending with the first Fed hike in nearly a decade. Adding to the angst, this tightening cycle will be very different from previous ones. The unconventional nature of monetary stimulus will demand an equally unorthodox exit. Massive excess reserves in the banking system and the proliferation of non-bank financing require the Fed to expand its tool kit from the more traditional Fed Funds rate, which banks charge each other for overnight lending.

Investors will need to get used to a new set of policy levers, including interest on excess reserves (IOER) and overnight reverse repurchase agreements, with the latter aimed at non-bank lenders. There will also be the question of when the Fed stops reinvesting proceeds from maturing bonds and instead allows its balance sheet to start to contract. Given the likelihood of a lower speed limit to U.S. growth, this tightening cycle is likely to cease at a lower terminal rate than previous cycles. As a result, both for the Fed and for investors, we are in unchartered territory, a fact likely to increase anxiety and uncertainty throughout the cycle.

Not only have rates been unusually low in a nominal sense, they have been even lower when adjusting for inflation.

While the United States has been flirting with disinflation for much of the past six years, unlike Europe or Japan, we have not seen outright deflation. Inflation has been low, but positive and relatively stable. With nominal rates locked in at zero, this means that real yields—yields after inflation—have been negative (see Figure 2).

While the real Fed Funds rate was negative back in the 1970s, this was a function of unusually high inflation rather than low rates. During the past 55 years, real rates have averaged around 2%, right in line with most academic theory. The current period of intentionally negative real short-term rates is highly unusual, at least in the United States during the post-WWII period.

FIGURE 2: U.S. REAL EFFECTIVE FEDERAL FUNDS RATE 1960 to Present EFFECTIVE FED FUNDS - RATE MINUS INFLATION (%)

EFFECTIVE FEDERAL FUNDS RATE (%)

20%

12%

9

6

3

0

-3

[4]

NO EXIT: CAN THE FED NORMALIZE RATES—AND HOW WILL IT IMPACT STOCKS?

1/31/10

5/31/13

9/30/06

1/31/00

Source: Bloomberg 4/15/15. Inflation is measured by Core PCE (personal consumption expenditure).

5/31/03

9/30/96

1/31/90

5/31/93

9/30/86

1/31/80

5/31/83

9/30/76

1/31/70

5/31/73

9/30/66

1/31/60

5/31/63

-6

THE END DAYS? After this many years of such generous monetary accommodation, more than a few investors believe that the entire edifice of the bull market has been built on a foundation of cheap money, a situation that is about to end. Accordingly, more than a few investors are worried about the impact of any marginal tightening.

FIGURE 4: S&P 500 RETURNS FOLLOWING RISING FED FUNDS RATE 1955 to Present 9%

7

We would agree with the view that monetary policy has been one of the principal catalysts and sustainers of this bull market. But given that any tightening is likely to be gentle and from an exceptionally low base, we’re skeptical that an initial rate hike will herald the end of the rally. True, this time is different. However, it is important to note that tighter monetary conditions are generally associated with more volatility and downside risk, not bear markets.

6

Looking at rate cycles for various periods going back to the 1970s, we looked at forward 3-, 6- and 12-month returns on the S&P 500 following an initial change in the Federal Funds target rate (see Figure 3).

0

For the entire period, a fairly clear pattern emerges. Initially, markets reacted negatively to the start of a tightening cycle.

Regardless of the period, 3-month returns following the start of a period of steady tightening were on average negative.

However, looking out 6 or 12 months, markets rebounded and generally produced positive, albeit subpar, returns.

FIGURE 3: RATE HIKES DO NOT IMPLY END TO LONG-TERM PERFORMANCE 8% 6.7

6.4

6.0

4.4

S&P 500 PRICE RETURN (%)

4

3.6

4.1

1.9

0

-2.3

-2.4 -4

-3.9

8.05

8

5.09

5 4.01

4 3.00

3 2

1.97 1.42

1 3m Forward

6m Forward Following Fed Hikes

12m Forward Sample Average

Source: Bloomberg 4/15/15. Index returns are for illustrative purposes only. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Using a slightly different methodology, we came to a similar conclusion. Going back to 1955, we examined periods following a one percentage point rise in the effective Fed Funds rate. We identified 16 such periods. Similar to the previous exercise, returns following these episodes were generally positive, although below the average (see Figure 4).

MULTIPLES MATTER These averages hide a significant amount of variation in returns. In trying to get at a more precise estimate of the impact of a rate hike, we tried to isolate other variables investors should be watching. One that has mattered historically has been the direction of equity valuations. In the past, U.S. equity markets have been more resilient to tightening monetary conditions if valuations were flat or lower over the preceding 12 months. Put differently, markets characterized by multiple expansion—in other words, when investors are paying more per dollar of earnings—are more vulnerable to a change in monetary conditions.

-4.3

-6.6 -8

1994

1999

2004 3mo

6mo

Average 12mo

Source: Bloomberg, S&P 500 Price Return (%) after the start of a tightening cycle. Index returns are for illustrative purposes only. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

B L A C K R O C K [5]

been expanding over the past year. To the extent that higher valuations are normally associated with momentum, another way of saying this is that strong market momentum trumps a tightening cycle, at least in the short term.

FIGURE 5: S&P 500 RETURNS FOLLOWING RISING FED FUNDS RATE 1955 to Present 12%

However, over longer horizons markets characterized by multiple expansion are more vulnerable to a tightening cycle.

Over 6 and 12 months, the S&P 500 has historically performed much worse following the start of a tightening cycle if valuations had been rising in the previous year. Given that U.S. equity market valuations have been consistently rising since 2011, this should give investors pause.

10.78

8

4.40

4 2.24

1.20

0.79 0

-4

THE REAL STORY -2.22 3m Forward

6m Forward P/E Contracting

12m Forward P/E Expanding

Source: Bloomberg 4/15/15. Index returns are for illustrative purposes only. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

In the next exercise, we used the same methodology—rising effective Fed Funds rate—but divided the instances into two samples: those in which equity valuations had been rising on a year-over-year basis and periods when valuations had been falling. The results are both intuitive and instructive (see Figure 5).

In the very near term of 3 months, U.S. stocks actually perform better in the beginning of a tightening cycle if multiples have

Another way to examine the impact of changes in monetary conditions is to focus on real rather than nominal rates.

The problem of focusing exclusively on nominal interest rates is that a rise in nominal rates may not represent a de facto monetary tightening to the extent that inflation is rising even faster.

The tables below quantify performance for the S&P 500 following periods when the real Fed Funds rate (defined as the difference between the nominal Fed Funds rate and the PCE) has been rising or falling over the previous 12 months.

The first table (see Figure 6) quantifies average price returns over the next 12 months. The second table quantifies the “win ratio” for the market (defined as the percentage of time the market rises over the subsequent 12 months) following periods of rising or falling real rates (see Figure 7).

FIGURE 6: S&P 500 PRICE RETURNS OVER 12 MONTHS WITH REAL RATES RISING OR FALLING

FIGURE 7: PERCENTAGE OF TIME S&P 500 RISES OVER 12 MONTHS WITH REAL RATES RISING OR FALLING

1960 to Present

1960 to Present Average Rt.

Count

1st Quartile

3rd Quartile

Real Rates Falling

9.44%

290

3.15%

19.32%

Real Rates Rising

6.33%

329

-4.87%

17.43%

Count

Market Up

% Win

Real Rates Falling

290

230.00

79.31%

Real Rates Rising

329

221.00

67.17%

Source: Bloomberg 4/15/15.

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NO EXIT: CAN THE FED NORMALIZE RATES—AND HOW WILL IT IMPACT STOCKS?

The results are similar to those derived from tracking changes in nominal rates. Markets generally perform better over the subsequent year when monetary conditions are easing rather than tightening.

What is interesting about the results is less the impact on the average return, which is fairly modest, but the extremes of the distribution. In addition to quantifying the average returns, Figure 6 also looks at the first and third quartiles of returns. Here the story is more interesting. Third-quartile returns are fairly similar, indicating that “good” years for the market are roughly the same regardless of monetary conditions. However, there are significant differences in first-quartile returns.

Over the past 55 years, “poor” years—defined as the first (or lowest) quartile of returns—tend to be much worse when monetary conditions are tightening rather than easing.

In other words, “bad” years are much worse when real rates are rising.

SHELTER IN SMALL CAPS? Today, many investors are looking at the headwind created by a stronger dollar on large multi-nationals and are rotating into small-cap stocks. Through the third week of April, the Russell 2000 Index was outperforming the S&P 500 by roughly 2%.

But assuming the Fed does indeed tighten later this year, small caps may not be the best place to hide.

FIGURE 8: RUSSELL 2000 PERFORMANCE IN RISING AND FALLING RATE ENVIRONMENTS 1984 to Present Average Rt.

Count

1st Quartile

3rd Quartile

Real Rates Falling

12.93%

197

4.54%

24.98%

Real Rates Rising

6.40%

167

-3.69%

17.31%

FIGURE 9: PERCENTAGE OF TIME RUSSELL 2000 RISES OVER 12 MONTHS WITH REAL RATES RISING OR FALLING 1984 to Present Count

Market Up

% Win

Real Rates Falling

197

157

79.70%

Real Rates Rising

167

110

65.90%

Source: Bloomberg 4/15/15.

While small caps’ revenue is more resilient to the impact of a rising dollar, their valuations have historically been more susceptible to rising real rates. In other words, the reduction in returns associated with tightening monetary conditions has historically been more acute in small caps. Following periods of rising real rates, average 12-month returns for the Russell 2000 are roughly half of the 12-month returns following periods of falling rates (see Figures 8 and 9). And as with large caps, downside risk is much greater during periods of rising rates.

Finally, win rates—the percentage of time the market rises— are modestly higher, roughly 80%, following periods of falling real rates. In contrast, following periods of rising real rates the win rate drops to around 67%.

B L A C K R O C K [7]

FIGURE 10: MONETARY POLICY AND MARKET PROFITABILITY 1990 to Present 25%

ROE S&P 500 (%)

20

15

10

5

0

-5

-4

-3

-2

-1

0

1

2

3

4

YoY CHANGE IN REAL FED FUNDS RATE (%)

Source: Bloomberg 4/15/15.

While the relationship between changes in monetary conditions and market performance appears fairly persistent, it is not entirely clear what accounts for it.

There are several possible reasons. Rising rates should have a negative impact on margins and profitability, thus lowering earnings. Rising rates could also have a negative impact by hurting end-user demand. A second possibility is that higher rates negatively impact stocks by raising the discount rate on future cash flows, in turn lowering the market multiple. In theory, investors should be less willing to pay up for a dollar of earnings when rates are higher.

Starting with the theory that higher rates are associated with lower profitability, historically we see exactly the opposite.

Looking back over the past 25 years, periods of higher real rates have generally been associated with higher profitability, measured by the return-on-equity (ROE) for the S&P 500 (see Figure 10). At least historically, the relationship has been fairly strong, with the year-over-year change in the real Federal Funds rate explaining roughly 30% of the variability in the ROE of the S&P 500. As a rough rule of thumb, for each percentage point the real Fed Funds rate rises, ROE typically increases by roughly two percentage points (see Figure 10).

While this at first seems counterintuitive, it is not hard to explain. Rising real rates typically occur in the context of an accelerating economy. To the extent an improving economy is lifting earnings, real rates and profits can rise together. Both are responding to the same underlying force: a stronger economy.

The negative relationship between real rates and equity returns instead seems to be a function of how investors value companies. In the past, rising real rates have been followed by periods of multiple contraction; falling real rates have generally been followed by periods of multiple expansion (see Figure 11). This is certainly consistent with what investors have experienced over the past six years.

As real rates have dropped and remained at record lows, multiples have steadily expanded.

FIGURE 11: CHANGE IN REAL FED FUNDS RATE & S&P 500 MULTIPLE 1960 to Present 14%

12M CHANGE IN P/E MULTIPLE (%)

MULTIPLE MECHANISMS

12.77

7

0 -1.21

-4.60 -7

Real Fed Funds Falling

Real Fed Funds Stable

Real Fed Funds Rising

CHANGE IN REAL FED FUNDS RATES PREVIOUS 12 MONTHS

Source: Bloomberg 4/15/15.

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NO EXIT: CAN THE FED NORMALIZE RATES—AND HOW WILL IT IMPACT STOCKS?

The relationship between changes in the real Fed Funds rate and changes in multiples parallels the situation with returns.

While the average degree of multiple compression following rising real rates is modest, sharp multiple contraction is more likely and more pronounced when real rates are rising.

Historically, the worst 25% of instances of multiple contraction are not that severe when real rates are falling.

Under that scenario, only 25% of the observations include instances when multiples contact by more than 6%. However, following instances of rising real rates, multiple contraction tends to be much worse. Under that scenario, the bottom quartile of observations is -16%. Bottom line: If real rates are rising, the downside risk from multiple compression is much more serious.

The Bottom line: If real rates are rising, the downside risk from multiple compression is much more serious.

This same conclusion holds for small caps, only more so.

While small-cap earnings are likely to hold up better in a rising dollar environment due to lower exposure to international sales, if the reason the dollar is rising is tighter monetary policy, small caps may not offer much in the way of defense.

Small-cap stocks tend to be more speculative. As such, periods in which monetary conditions are easing induce a “risk-on” mentality, benefiting the asset class even more than larger companies. Conversely, as monetary accommodation is removed, the impact also tends to be disproportionate. In the year following a rise in the real Fed Funds rate, small-cap multiples contracted in roughly 55% of the months. In contrast, following periods of falling real rates, multiples contracted only 35% of the time. Put differently, small-cap multiples are roughly 2.2 times more likely to compress in the year following a rise—measured as the year-over-year change—in the real Fed Funds rate.

This is a particular risk today as small-cap valuations have once again been on the rise. After falling for most of the past year, the Russell 2000 is trading at roughly 47 times trailing earnings, roughly a 20% rise from last fall’s bottom in valuations. The pattern looks the same based on price-tobook, which has risen by around 16% from last September, and is now at the highest level since the fall of 2007. The rise in valuations suggests that if real rates rise along with nominal rates, the small-cap rally is likely to fade.

BL ACK R O CK [9]

CONCLUSION “One often meets his destiny on the road he takes to avoid it.”

— Master Oogway, “Kung Fu Panda” A normalization in U.S. monetary policy is unlikely to herald a catastrophe. Both nominal and real rates will remain low for the foreseeable future. Not only is the Fed likely to take a slow and measured path, but secular factors—slower growth, demographics, technology—are also conspiring to keep rates down.

Still, the first rate tightening will represent a marginal change in the monetary regime. It has been nearly a decade since the Fed raised rates, and over the last several years volatility has been unusually low. This is likely to change as investors become reacquainted with what a tightening cycle feels like.

And while the cycle will be gentle, it will also be unorthodox, adding another layer of uncertainty as both the Fed and investors acclimate to unfamiliar tools and how to remove accommodation under the shadow of a bloated balance sheet.

Starting this fall, investors should, at the very least, expect more volatility and a heightened likelihood of a correction.

The risk may be even more pronounced for small-cap stocks.

The good news is that the risk and magnitude of a correction may be mitigated if inflation continues to stabilize. Modestly higher inflation would mean that real rates remain stable, even if nominal rates are being nudged higher.

Finally, and perhaps most significantly, it will not help that any hike will be occurring against the backdrop of a multi-year trend toward higher equity valuations. For the Fed, this is ironic, although it may not appreciate the irony. Recent comments and behavior suggest that Fed officials are keenly aware of and somewhat nervous over the potential risk to financial markets.

If history is any guide, the risk is greater precisely because the Fed has put off the inevitable for so long.

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B L A C K R O C K [11]

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