by Joe Herrle, CFA
Vice President, Alternative Assets
On Wednesday, the Federal Reserve lifted their key interest rate by 0.25% in the first of six expected rate hikes for this year, and possibly another four proposed increases in 2023. Federal Reserve Chair Jerome Powell had indicated that this increase was coming. So, when the stock market rose on Wednesday in response, it was less about the rate hike itself and more about Powell’s language associated with the move.
The Fed follows a dual mandate to manage employment and provide price stability (by controlling inflation), but they always consider broader economic conditions when changing policies. While some might worry an increasing interest rate might hurt employment and the economy overall, multiple indicators reveal that the economy is currently on very stable footing. Powell’s remarks on Wednesday confirmed this view.
Even with 11 anticipated rate increases through 2023, Powell stated, "the probability of a recession within the next year is not particularly elevated." He cited strong aggregate demand, a tight labor market and strong household balance sheets as reasons they (the Fed) believe the economy can handle the rate increases. He affirmed, "all signs are that this is a strong economy and, indeed, one that will be able to flourish."
So, what do increasing rates mean for the stock market? Historically, stock market returns have been positive most of the time when there have been four or more rate hikes. However, the most recent instance in 2018 saw a negative return. Simply put, rate increases are not a strong indication of negative equity returns in the near term.
On the other hand, bonds have very clear inverse relationship with interest rates, namely, when rates go up, bond values go down. Additionally, inflation negatively impacts bond prices. While bonds still play a defensive role as a stabilizing force in portfolios, the Bloomberg Barclays Aggregate Bond Index has taken quite a beating this year. There is still much more to play out through the end of the year, but the current year-to-date negative return of over 5% would make 2022 the worst year on record for the index.
Our view beginning in 2020 was that bonds would not provide the returns of the past over the medium-term, and consequently, we have been the most underweight to bonds in firm history. The recommended reduction in bonds came with an increased allocation to alternatives. So far, this shift has paid off as our income-focused alternative offering, the Absolute Return Income Strategy, outperformed bonds last year. Additionally, the strategy has generated a positive return this year.
The Absolute Return Income Strategy aims to produce an attractive level of income distributions like bonds but with different sensitivities to inflation and interest rates. Typically, inflation negatively impacts the underlying asset classes of real estate, farmland, timberland and infrastructure to a much lesser extent than bonds. Private credit, the fifth asset class in the strategy, also has the added benefit of being mostly floating rate bonds. Thus, when market interest rates increase, the interest payment from the private credit loans increases. These alternative asset characteristics lend credence to our view that the asset class will play an essential role in portfolios for the foreseeable future.
Our Takeaways from the Week
The Fed believes current robust economic conditions can weather increased rates while taming inflation
Higher interest rates are generally negative for bond returns, but the relationship with stock market returns is less obvious