Market slumps and the interest-rate cycle

The dismal start to 2016 has provided an interesting insight into investors’ capacity to switch their perception of the glass from half full to half empty. Two pieces of conventional wisdom have been turned on their heads so far this year.

Take the fall in the oil price. At the end of last year, cheaper energy was widely seen as a good thing, better for consumers’ disposable income and better for companies’ input costs. Fast forward to today’s risk-off world and the same conditions are seen as a drag on energy companies’ profits and a threat to the banks who lent to them in the good years.

As for interest rates, there has been a similar U-turn. Until recently, the prospect of lower-for-longer interest rates has been viewed positively. The reason markets seemed to take December’s Federal Reserve rate hike in their stride was the implicit promise that further increases would be slow and gradual. Less than two months later and investors seem to have decided that the Fed’s caution on future hikes merely confirms that the global economy is in a fragile state.

For the banks in the eye of the current market storm, the prospect of lower-for-longer interest rates is now seen as unequivocally bad news. Banks lend at higher long rates and fund their loans with cheaper short-term money. That neat trick stops working when worries about growth squeeze long rates lower and there is nothing left in the middle for the lenders.

Recently three London Business School professors - Dimson, Marsh and Staunton – stepped into the debate about whether interest-rate hikes are a good or a bad thing. Each year the LBS Three crunch a huge database of stock market data (running all the way back to 1900) for Credit Suisse’s annual Investment Returns Yearbook – this year, with impeccable timing, they have decided to put interest rates under the spotlight.

The beauty of interest-rate and stock-market cycles for number crunchers is the fact that they are completely measurable. There’s no ambiguity about when rates change or the performance of markets following those changes. Thanks to the interest-rate futures markets it is also possible to be precise about what the market expects about the direction of rates.

On the basis of the LBS evidence, we should not be surprised that market sentiment has soured so quickly after the Fed’s first rate rise since 2006. As the report suggests, hiking does seem to be bad for your wealth. In the hundred or so years between 1913 and 2015 American shares returned a real inflation-adjusted return of 6.2% on average each year. But this disguises a significant difference in performance between loosening cycles (between peak and trough interest rates) and tightening periods (from the low point in the interest-rate cycle to the first cut at the top).

Loosening cycles produced an average real return for US shares of 9.3% while during tightening cycles the return was just 2.3%. In the UK between 1930, when comparable figures became available, and 2015 it was exactly the same story – a 6.2% average return, with 8.2% in the loosening cycles and 1.7% when rates were rising.

If a case can be made for timing investments according to the interest-rate cycle, what about shifting assets within a portfolio according to movements in the cost of money? Again, the evidence is apparently conclusive. Looking at returns by sector during loosening and tightening cycles it is clear that the defensive sectors that do relatively well when policy is tightening (healthcare, utilities and telecoms, for example) do relatively badly when rates are falling. Meanwhile, the sectors that enjoy the loosening cycle (consumer durables and retailers, for example) are relative underperformers when rates rise.

A word of caution, however. If you think this means you should simply re-arrange your portfolio at the tops and bottoms of the interest-rate cycle, the small print of the report provides a salutary warning that investment is never that easy. While history can provide clues about the future, averages can hide a multitude of sins. In this case, the professors admit that 40% of the time equities actually performed better during a hiking cycle than in the easing phase that preceded it.

This makes sense when you think about all the moving parts surrounding interest-rate cycles. Rates generally rise when the economy is improving and fall when conditions are deteriorating, providing an unpredictable two-way pull for asset prices. Moreover, markets anticipate future rate movements so central-bank policies are often priced in before the event. It is surprises and changing expectations that move markets and the half empty glass can quickly look half full again.