Archives For interest rates

Quiz!

Which is the best diversifier for US tech stocks?

  1. Cash
  2. Bonds
  3. US Value Stocks
  4. Emerging Markets Stocks
  5. Emerging Markets Value Stocks
  6. Bitcoin

A Great Diversifier to Hi-Tech

If you work in hi-tech, your financial position could be greatly influenced by the hi-tech cycle. Your income comes from hi-tech. In addition, If you have any stock options, stock grants or actual stocks of your company, they all depend on hi-tech. Even if you do not work in hi-tech, but most of your clients do, you are very dependent on this sector. When constructing your investment portfolio, it is worth being aware of this. It may be tough to diversify, if you believe that the strong run of hi-tech in recent years will never stop. To understand how a reversal is possible, note that valuations (price/book) of tech stocks surged in the past 10 years. This means that people are paying substantially more (price) for company values (book). This is in contrast to company values (book values) improving as much as the price gains, leading the price/book to stay flat over these years.

You may be discouraged by the fact that interest rates are low and expected to go up, and inflation has spiked. Commonly discussed candidates for moderating the risk of expensive tech stocks, including bonds and cash, can get hurt by rising interest rates and inflation.

There is a solution that doesn’t require accepting the typical low returns of bonds and cash, and without giving up the liquidity of stocks. This solution is especially helpful when interest rates and inflation go up. The solution is Value stocks, especially in other countries. When US tech stocks declined for over 10 years starting in 2000, Emerging Markets Value stocks grew substantially. This occurred at a time of extreme valuations for tech stocks, just like we are experiencing today. So, while any investor should be cautious of a concentration in high-tech stocks today, if your income is tied to hi-tech, you have a good diversifier available now.

Note that diversified Emerging Markets Value funds already have an allocation to high-tech stocks (while emphasizing lower valuations than typical), so they don’t require a separate allocation to high-tech.

Quiz Answer:

Which is the best diversifier for US tech stocks?

  1. Cash
  2. Bonds
  3. US Value Stocks
  4. Emerging Markets Stocks
  5. Emerging Markets Value Stocks [Correct Answer]
  6. Bitcoin

Explanations:

  1. Cash offers zero volatility, and seems perfectly safe. The issue is that it loses money to inflation. With a modest 3% inflation rate, you lose 50% every 24 years.
  2. Bonds offer low volatility, at a price of low returns. While they may seem compelling, they can decline when interest rates go up, and they can lose value relative to inflation.
  3. US Value Stocks are a good diversifier given that they are helped by rising interest rates and inflation, while tech stocks tend to get hurt by those. They are still subject to US-specific country risks, so are not the best.
  4. Emerging Markets Stocks diversify the US-specific country risk, but there is still better!
  5. Emerging Markets Value Stocks diversify the US-specific country risk, and are also typically helped by rising interest rates and inflation, while tech stocks tend to get hurt by those.
  6. Bitcoin is a currency, with no expected positive returns. But, it is far worse than cash, because it is extremely volatile. In addition, people were drawn to it in recent years given the high past returns, similar to tech-stocks. As seen recently, they can experience declines together with tech stocks. This is opposite of what some speculated, thinking that it may be a good inflation hedge.
Disclosures Including Backtested Performance Data

Quiz!

What typically happens to stocks when interest rates & inflation rise?  (There may be multiple answers.)

  1. Stocks go down.
  2. Stocks go up.
  3. Growth (high P/B) stocks go down.
  4. Growth (high P/B) stocks go up.
  5. Value (low P/B) stocks go down.
  6. Value (low P/B) stocks go up.

Look for the answer below and read this month’s article for a discussion.

What Happens When Interest Rates & Inflation Rise?

Optimism about the pandemic’s direction led to expectation for inflation along with rising interest rates in the past month.  The direct impact of inflation and rising rates is damage to stocks & bonds.  This is especially true for growth (high P/B) stocks that obtain much of their value from earnings far into the future – earnings that are less valuable, the higher the inflation.

Beyond the initial reaction, value and Emerging Markets (EM) investments tend to do very well from conditions like today.  The closest example is the behavior of Extended-Term Component (ET) in 2003.

Extended-Term Component (ET) Behavior with Expectation for Higher Interest Rates and Inflation
6/9/2003 2/26/2021
ET P/B 0.93 1.01 (lower equivalent given the profitability tilt since 2014)
Time since recent low 8 months 11 months
10-year treasury rates Increased fast (2% in 2 months) Increased (1% in 7 months)
Federal rates went up starting 1 year later (6/30/2004) ?
Federal rates went up by 4.25% in 2 years! ?
Dollar High and declining High, and peaked recently
ET gained An additional 449% in 4.5 years ?

Every case is different, and I don’t necessarily expect a repeat gain of 449% in 4.5 years.  This information shows that rising rates have not been bad for your investments historically.

Note that in the example above, growth stocks also did very well, but their valuations were substantially lower than today.  Between the positive forces of the economy and stimulus and the negative impact of extreme valuations, it is tough to predict gains or declines for growth stocks.

While I cannot predict future returns, there are a number of factors that would lead me to optimism for both EM and Value investments in upcoming years.  Here is some logic:

  1. Interest rates reached record lows in recent months, and there are mounting forces for higher interest rates and inflation.  This hurts growth stocks, making value stocks more attractive on a relative basis.
  1. During economic recoveries, cyclical value stocks tend to do especially well.
  1. The dollar is relatively high, and has plenty of room to go down, increasing the value of non-US investments.
  1. An economic recovery from the pandemic would lead to a benefit for stocks in general, especially ones that are not already priced high.  The discount of value stocks relative to growth stocks is still at a real extreme.
  1. Beyond value vs. growth, EM Value stocks are priced extremely low relative to US Value stocks.

While the 2003 example above seems most relevant, a more recent situation of rising rates was 2016-2017, where ET enjoyed a 99% gain in about 2 years, within weeks after the Fed started raising rates.  To emphasize, no specific result is guaranteed, but fear of rising rates hurting EM and Value stocks would not be rooted in past experience.

Quiz Answer:

What typically happens to stocks when interest rates & inflation rise?  (There may be multiple answers.)

  1. Stocks go down.
  2. Stocks go up.  [Correct Answer]
  3. Growth (high P/B) stocks go down.
  4. Growth (high P/B) stocks go up.  [Correct Answer]
  5. Value (low P/B) stocks go down.
  6. Value (low P/B) stocks go up.  [Correct Answer]

Explanations:  In general, stocks tend to go up when interest rates & inflation go up, reflecting an expanding economy.  Value stocks tend to outperform growth stocks, as the higher rates & inflation hurt the value of future earnings.  Note that the valuations of growth stocks are extremely high at this point, so it is tough to project their future.

Disclosures Including Backtested Performance Data

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