Archives For interest rates

Quiz!

Would you expect emerging markets investments to go up or down when interest rates go up in the US?

  1. Up.
  2. Down.

Do Rising U.S. Interest Rates Hurt Emerging Markets?

There is a widely held belief that when the US Fed (Federal Reserve) raises interest rates, emerging markets investments should decline.

Why do people expect emerging markets to get hurt when US rates go up?

  1. Stronger dollar: When US rates go up relative to rates in other countries, people can earn a higher rate on savings in the US. This would lead to money flowing from other countries to the US, which would strengthen the dollar.
  2. Higher borrowing costs for emerging markets: Many emerging markets companies borrow in dollars. If a Chinese company earns money in yuans and borrows in dollars, a stronger dollar would make the loan more expensive in yuans, hurting the company.

Reality is the opposite!

While the logic seems sound, reality in the past 20 years has been the opposite. The table below tracks the returns of ET (Extended-Term Component), a portfolio focused on emerging markets, in periods of rising and declining rates in the US:

Period Start

Period End

Change in US rates

ET Returns

12/31/1998

5/16/2000

+1.75%

+58%

5/16/2000

6/25/2003

-5.50%

-11%

6/25/2003

6/29/2006

+4.25%

+169%

6/29/2006

12/15/2015

-5.25%

+20%

12/15/2015

9/28/2018

+2.00%

+50%

Observations & notes:

  1. In all rising-rate periods, ET gained substantially.
  2. In declining-rate periods, ET had much worse results, with negative to low-positive returns.
  3. Market tops and bottoms didn’t coincide perfectly with the borders between the periods. Measured from the turning points in the portfolio, the results are substantially stronger.

Why do emerging markets go up when US interest rates go up, and vice versa?

The Fed reacts to the world economies when setting the interest rates. It focuses on the US, but considers the rest of the world as well. Specifically:

  1. When the economy shows signs of weakness after a period of expansion, the Fed lowers rates, to support the economy.
  2. When the economy turns around after a period of contraction, the Fed raises rates to moderate the expansion.

While I wouldn’t count on emerging markets to go up perfectly whenever US rates go up, the data is useful in avoiding expecting the opposite.

Quiz Answer:

Would you expect emerging markets investments to go up or down when interest rates go up in the US?

  1. Up. [The Correct Answer]
  2. Down.

Explanations: Read this month’s article for an explanation.

Disclosures Including Backtested Performance Data

Quiz!

In the past 20 years, how did Extended-Term Component perform in a period of rising rates from low rates?

  1. It gained more often than declined.
  2. It declined more often than gained.
  3. It gained consistently in all cases.
  4. It declined consistently in all cases.
  5. As with most things, the results were mixed.

What do Stocks do when Interest Rates Rise?

This article reviews the impact of rising rates from a low point on the high-volatility high-growth stock portfolio Extended-Term Component, both empirically and logically.

 

Empirically: We have 2 cases of rising rates from a low point in the live history since 1998:

Increase Date Starting Rate Trend information Performance since rate increases started Duration Rates before peak portfolio
6/30/2004 1% Gain started 1.5 years earlier +277% 3.3 years Reduced for a month after plateaued for over a year
12/17/2015 0%-0.25% Gain started after a short-lived (35 days) 12% decline +61% so far (including the initial decline) 2.2 years so far Peak not established yet

So far, we enjoyed phenomenal gains in both cases. While this data is not statistically significant, these strong results dispel the myth that you should expect declines when rates go up. So far, all [2] cases go against this theory.

Logically: The Fed acts in reaction to US and non-US economic activity. It lowered rates as a result of poor economic performance, in an attempt to stimulate the economies. Very low rates tend to be a result of big financial shocks, as we have seen in 2000-2002 and 2008. After these big shocks, the Fed was slow to reverse course and raise rates, because the risk of deflation seemed greater than the risk of inflation. By the time it raised rates, there were clear signs of economic improvement around the world. Additional rate increases were done cautiously after the economies continued to improve. The positive effect of economic improvements was greater than the negative effect of rising rates, by design. In addition, with such low starting rates, it took a long while for rates to stop being accommodative to the economy.

More Good News: While stocks did well as rates went up from low levels, you may expect stocks to get hurt when rates reach higher levels. In the history we have since 1998, the 1-year return leading to high peaks, when interest rates reached a cycle-high, was not only positive, but unusually high: The 1-year return was 92% leading to the 2000 peak, and 73% leading to the 2007 peak.

Quiz Answer:

In the past 20 years, how did Extended-Term Component perform in a period of rising rates from low rates?

  1. It gained more often than declined.
  2. It declined more often than gained.
  3. It gained consistently in all cases. [The Correct Answer]
  4. It declined consistently in all cases.
  5. As with most things, the results were mixed.

Explanation: Please read this month’s article for an explanation. Note that while the results were consistent, there were only two instances in total over 20 years, so these results are not statistically significant. A conclusion that is safe to make: we cannot count on high odds of declines as rates go up, because the history so far goes strongly against this theory.

Disclosures Including Backtested Performance Data