Indexology^® Blog

As the Fed prepares to raise interest rates on Wednesday – or surprise virtually everyone – it is worth looking at the debt in the economy.  Interest expenses for most of it won’t move very much or very soon, but some believe the Fed is embarking on a two to three year process of pushing interest rates every upward.

The chart tells the story.  The pale green line with the peak at about 2008 is the domestic financial sector – banks, brokerages, insurance companies and so forth. Like most sectors, this one peaked as the financial crisis hit; unlike some sectors it has paid down a lot of debt and then resumed its climb. Since the mid 1990s the growth of financial sector debt outpaced everything else, it may be poised to outpace most other sectors going forward.  The red line – home mortgages — has the second largest dip after financials and it too is recovering.  Neither of these suggests a major change or retrenchment following the financial crisis.  Another sector that gets a lot of attention is the pink line trying to flatten out in the latest couple of quarters – federal government borrowings.  Corporate business, the gold colored line, staged a sharp rise in the last few years.

The bottom four sectors are a bit more stable and represent foreign borrowing in the U.S., state and local government debts, consumer credit and non-corporate borrowing.

The message here is two parts: one reason the last recession was called the Great Recession is the large and rapidly growing debt throughout the economy in 2007-2008; second is the hope that a small rise in interest rates and borrowing costs will moderate the current growth rates well before the next recession.

Tomorrow the Federal Reserve is expected to raise its benchmark Federal Funds rate by 25 basis points  — the first increase in seven years.   This increase, assuming that it comes, must surely rank among the Fed’s most advertised and anticipated moves ever, and Wall Street trading desks are ramping up in expectation of heightened trading volumes.   We have no special insight into the immediate or longer-term aftermath of the Fed’s decision — but we would caution that, for equity investors, there are at least three things that rising interest rates will not do.

First, they won’t tell us whether the stock market is going up or down.  There are good theoretical arguments to support the view that rising rates are bad for stocks.  If dividends are discounted at a higher rate, stock prices should come down, other things equal.  The problem is that other things may not be equal.  If rate increases come in response to a strengthening economy, they may be associated with rising stock prices.   In recent years, in fact, the U.S. equity market has been stronger when interest rates rose than when they fell.

Second, rising rates won’t cause stock market dispersion to increase.  Dispersion indicates by how much the best performing stocks in the market are beating the underperformers.  In a high-dispersion environment, a manager’s stock selection skill is worth more; if dispersion is low, his skill is less valuable.  Dispersion has been well below average for the past several years, which has contributed to the performance difficulties of most active managers.  But there’s no reliable evidence to suggest that an increase in interest rates will drive dispersion upward.  Whatever difficulties stock selection strategies faced with the Fed Funds rate at zero are likely to persist at 25 basis points.

Finally, rising rates won’t help us identify outperforming equity factors.  Rising rates don’t give us a reliable guide to the relative performance of growth vs. value, say, or of low volatility vs. high beta.  Through the first 11 months of the year, growth is well ahead of value, and low volatility well ahead of high beta.  Whether those trends continue or reverse is unlikely to depend on what the Fed does tomorrow.

Energy has been the hot topic in regard to investments.  The drop in the price of oil (USD 37 per barrel) and prolonged low values of many commodities (S&P GSCI, -33% YTD) has added concern to an already nervous bond market.  The expectation that the U.S. Federal Reserve would follow through on its assumed intention to start raising rates after its Dec. 15–16, 2015, round of meetings already had market participants on edge.  Current events in the bond and commodity markets have added a heightened sense of unease.

In this market environment, interest in energy has taken on a life of its own.  The Materials sector can also be included in the concern group as the sector is highly related to commodities such as chemicals, metal & mining and construction materials.  As a point of information and comparison, Exhibit 1 gives insights into a few of our key indices.

Exhibit-1: Index Industry Weights

As 2015 inches closer to the final bell U.S. municipal bonds are leading the returns as we near the halfway point of the final lap.

As of December 14th, 2015….

The S&P Municipal Bond Investment Grade Index has recorded a total return of 3.09%.  Key factors for the muni market in 2016 include:

• Real new issue supply excluding refunding bonds could grow in 2016.  This would be a welcomed sign for the muni market but will test the demand side of the equation.
• Demand for better quality municipal bonds has been strong and could remain strong in 2016.
• Defaults in the municipal segment are few but make powerful headlines.  Puerto Rico remains the largest drag on the overall muni market.  These events should support the higher grade portion of this market.

The S&P Municipal Bond High Yield Index has also shown positive returns of 2.51%.  Key factors for the junk muni bond market in 2016 include:

• Puerto Rico resolution or steps toward resolution.
• Low real new issue supply of higher yielding municipal bonds helps keep the imbalance between demand for yield and supply off kilter.

U.S. Corporate bonds tracked in the S&P 500 Investment Grade Corporate Bond Index have just about returned 0% and the S&P 500 High Yield Corporate Bond Index has returned -4.68% so far in 2015.  The market for these bonds in 2016 may be affected by:

• Expected lower new issue supply of investment grade bonds.
• A decline in the energy bond and mining related debt markets.
• Rising rates impacting the yield curve: i.e. flattening or steepening the curve.  Expectations are that flattening is more likely.
• Credit spreads widening in the junk sectors.

Table 1:  Select Fixed Income Indices Yields and Total Returns

Table 2: S&P 500 and S&P GSCI Total Returns

The concentration of bonds trading in the secondary market rises the weaker the credit quality of bonds.

The distressed segment of the junk bond market has the most concentrated trading activity indicating that the majority of bonds in that segment are significantly less liquid.

The top 20% of bonds in the S&P U.S. Distressed High Yield Corporate Bond Index in November represented:

• 86% of the total number of trades that occurred in that quality segment.
• 75% of the total market value of trades that occurred in that quality segment.

For comparison, trade data for other quality based indices is in the table below.

Table 1: Select Indices and Corresponding Trade Volume Statistics on the Bonds In Those Indices (Month of November 2015).