During the past year, daily equity market declines and gains exceeding 1% have been common, with investor sentiment quickly changing based on the prevailing outlook for the Federal Reserve’s monetary policy. At times, favorable economic news, including encouraging job creation numbers, has caused investors to sell equities based on fear that the Fed would stymie the country’s recovery and hurt corporate profits by rising interest rates.
At other times, disappointing economic news has caused euphoria as investors flock to stocks with the belief that low interest rates will continue to juice corporate earnings and stimulate the economy. In the process, investors have overlooked the country’s slow but steady economic growth and encouraging corporate fundamentals.
For advisors, such times of turmoil are an opportunity to add value by helping clients sleep at night by dispelling common interest rate myths. At the same time, advisors can use interest rate fears as an opportunity to emphasize the merits of taking a long-term approach to investing and managing risk with portfolio diversification.
Advisors should start by explaining to clients that fears over rising interest rates are overblown and that Fed rate increases typically support, rather than harm, equity markets. Indeed, a recent Bloomberg analysis of market data going back to 1952 has concluded that stocks, on average, have climbed 4.2% during the first six months after the Fed starts increasing interest rates and 5.8% in subsequent six-month periods.
Broadly speaking, increased costs of financing for corporations have been offset by favorable economic conditions for businesses. For example, rate increases occur when declining unemployment and strong consumer sentiment support retail shopping, so companies have increased opportunities for growing their revenues and earnings.
At the same time, rate increases can help strengthen profit margins for banks, brokerages, and insurance companies.
Advisors should also point out that interest rate increases and the Fed’s move away from an accommodative policy are expected to be mild. Regarding overall interest rates, debt securities worldwide are producing historically low yields. In some countries, debt is even providing negative yields. As a result, foreign investors have been snatching up U.S. corporate and government bonds that have been offering higher yields.
Since bond yields move in the opposite direction of prices, the increased buying of U.S. debt by foreign investors is likely to help maintain a low interest rate environment even if the Fed changes its accommodative policy.
After making those points, advisors should emphasize that corporate fundamentals remain strong and that it’s important to maintain a long-term investing perspective to ride out market volatility.
At first blush, of course, corporate earnings growth appears to be moderating. Yet, after accounting for the impact upon the energy and industrials sectors of low oil prices and the impact upon exports of a strong U.S. dollar, earnings have been encouraging. That’s especially true in sectors such as information technology that are benefiting from the rapid growth of Internet-based services.
From a long term perspective, consumer spending has also been strengthening as Americans are seeing their spending power increase as they pay lower prices for gasoline and heating oil.
Corporations are also increasing their dividends, conducting mergers and acquisitions, and performing stock buybacks, all of which are providing additional support to equities.
At the same time, advisors should remind clients that periods of market declines are often followed by strong equity gains. For example, after the S&P 500 dropped to a low for the year in August following concerns over China’s moderating economic growth, it quickly snapped back and has generated an approximately 10% return since then.
While no one can forecast market directions with utmost certainty, advisors should also point out that from a historical perspective, longer periods of equity declines have eventually been followed by sustained market recoveries.