There’s been some good economic news recently.
Unfortunately, that’s the bad news.
Last Friday’s jobs report showed hiring was stronger than expected, unemployment edged lower and wage growth picked up.
Normally, you hear that and think, “Well, that sounds pretty good.”
And it is…unless you’re the Fed.
The Fed’s been trying to cool the economy so inflation will come down. Instead, people keep getting jobs and making more money.
Then came the inflation report. Core consumer prices rose 0.30% in October versus the 0.20% expected, with increases across housing, medical services, auto insurance, hotels, and airfares.
As of today, the market is pricing in one full rate hike by the Fed’s December 9 meeting. After last Friday’s jobs report alone, the probability of one hike was 77.5%.
Together, the reports suggest the economy isn’t cooling down as quickly as the Fed would like. Which leaves policymakers in the unusual position of looking at strong employment and saying, “Could we have slightly less of that?”
Markets responded: U.S. Treasury yields rose, stocks fell, and the U.S. dollar strengthened as investors weighed the possibility that interest rates could stay higher for longer.
Fed Governor Christopher Waller added to the conversation on Tuesday, saying he supports a December rate hike and that a half-percentage-point increase should be considered if inflation proves substantially hotter than expected.
Half a percentage point doesn’t sound like a large number. Unless it’s an interest rate. Then everybody gets very interested in the half.
Next up are tomorrow’s Producer Price Index report and the Personal Consumption Expenditures report later this month. Investors will be watching both for more information about inflation and what the Fed may do next.
There may even be good news. Which, as we’ve established, could be terrible.
Advisor angles
These talking points can help you answer client questions about what stronger economic data and the prospect of higher-for-longer interest rates could mean for their portfolios.
What does this mean for my portfolio?
For clients, the implications extend beyond another quarter-point Fed rate increase. How long rates remain elevated can affect the outlook for bonds, cash, equities, and economic growth.
What could higher rates mean for my bonds?
If market yields rise, existing bond prices generally fall. Longer-duration bonds typically experience larger price movements, all else equal.
Higher yields can also increase the income available on newly purchased bonds and, over time, within portfolios as securities mature and cash flows are reinvested.
Existing bonds may therefore lose value when newly-issued bonds offer higher yields.
Why does duration matter?
Duration helps estimate how sensitive a bond or bond portfolio is to changes in market yields.
Longer-duration bonds generally experience larger price changes when yields move, falling more when yields rise and gaining more when yields decline, all else equal.
Understanding a portfolio’s duration helps put its interest-rate exposure in context.
If cash is paying attractive yields, why not just stay there?
A higher short-term-rate environment can support yields on cash and short-term investments. But those yields can adjust relatively quickly if rates eventually decline, leaving investors to reinvest maturing money at lower rates. This is called reinvestment risk.
Does higher for longer mean stocks are in trouble?
Not necessarily.
Higher rates can create a valuation headwind because future corporate cash flows are discounted at higher rates. Higher borrowing costs can also affect some companies’ expenses and investment decisions.
But stock performance also depends on earnings, economic growth, valuations, and what investors have already priced in.
Are some companies more exposed to higher rates?
Yes, but the differences can be company-specific.
Businesses with substantial debt or refinancing needs can be more exposed to higher borrowing costs. Companies whose valuations depend heavily on cash flows expected far into the future can also be more sensitive to changes in discount rates.
So, balance sheets, financing needs and valuations matter.
Could higher rates eventually become a bigger problem for the economy and earnings?
If restrictive financial conditions persist, higher financing costs can gradually weigh on interest-sensitive areas such as housing, consumer borrowing and business investment.
If that contributes to slower economic activity, corporate revenues and earnings can eventually feel the effect.
Monetary policy affects the economy with a lag.
Does any of this mean I should change my portfolio?
A change in Fed expectations is not, by itself, a change in an investor’s objectives, time horizon, liquidity needs or tolerance for risk.
The more useful conversation is about exposure: How sensitive is the fixed-income allocation to changes in yields? Where is portfolio income coming from? How much liquidity is needed? Which investments are particularly exposed to financing costs or changes in economic growth?
That keeps the discussion centered on the portfolio rather than trying to guess the next Fed decision.
Source: Bloomberg