While it is no surprise that there is nothing in this world that can derail the optimism of Goldman's David Kostin (GS S&P 2011 target 1,500 until Jan Hatzius and his double Bill Dudley say otherwise), in his latest Weekly Kickstart he does provide a useful visual analysis of what happens in a period of rising interest rate cycles. Of course, this is only to create the illusion that rates are indeed set to rise: as we indicated said illusion was roughly two times stronger this time last year when the market once again didn't remember what a downtick looked like, and yet it all turned out to be a function of QE1, which upon ending on March 31 caused a correction, and QE2 a few months later. We wonder how many professional investors actually are naive enough to equate constant pumping of billions of dollars into the market by the Fed with economic improvement. But while we will get our answer in the next several weeks, here are the key signs to look for in the latter part of the interest rate cycle.
The first chart looks at what happens when rates are rising. What is stunning is that the last time we had the commencement of a real interest rate rise was back in 2004. And even that ended up to be far too late to make an impact. Not to mention that all such hikes were in a period of lower lows. Too bad we can't go much below zero (thank you ZIRP).
The next table looks at sector and general market returns X months into a tightening period. For those who buy that much can be gleaned from IR analysis during the great 30 year moderation, the best sector to buy would be IT and Materials.
Then again, since the IT sector return is massively skewed due to the 32% performance from the 1998 dot com bubble, perhaps it is best to avoid it...
The most useless chart of all is the expectation for the Fed Funds rate by Goldman and consensus. In a year we will all be laughing about this one.
Next, for those who care, here is Kostin's traditionally permabullish commentary:
The news flow during 1Q 2011 was anything but market-friendly. But a devastating and tragic earthquake and tsunami in Japan, political upheaval across the Middle East and North Africa (MENA), and absence of agreement on fiscal issues in Europe and the US could not shake the bull market.
S&P 500 rose 5.4% during 1Q and ended at 1326, in-line with our forecast. Our year-end 2011 target remains 1500 reflecting a potential prospective nine-month price gain of 13%. If achieved, the 2011 price return would be 19% and rank 0.6 standard deviations above the average annual return since 1928. Despite the resilient market, investors remain uneasy and list various macro and micro headwinds to further index advances.
Foremost among the concerns expressed by equity fund managers during our recent meetings is the risk of higher interest rates. Bears argue that $600 billion of planned Fed bond purchases under QE2, if they end as scheduled in June, will cause long-term interest rates to rise and spark a sell-off in US equities. Investors also fear rising US inflation data and forward-looking inflation expectations will prompt the Fed to raise shortterm interest rates before year-end. Our Global ECS Commodities research colleagues note the risk of substantially higher energy prices, upside risk to gold prices, and a tight inventory situation across the major grains, with soybeans and corn particularly susceptible to upside spikes. During the past week several regional Federal Reserve bank presidents publicly discussed policy tightening, stoking investor concern about how stocks will perform when the Fed eventually begins removing liquidity (see US Daily: Fedspeak – Sharpening the differences, March 29, 2011). Finally, the ECB is widely expected to hike interest rates on April 7th, which will also draw investors’ focus to the timing of the Fed’s exit.
However, Goldman Sachs US Economics forecasts Fed Funds will remain unchanged at 0%-25bp through 2011 (and likely 2012 as well) and ten-year interest rates will drift slightly higher from 3.5% currently to 3.75% by year-end 2011 and 4.25% by year-end 2012.
From a US portfolio strategy perspective we are interested in how domestic stocks might trade when interest rates begin to rise. We analyzed seven episodes of rising US interest rates since 1975 (see Exhibit 1). The timing of the interest rate increases was consistent across the maturity spectrum (Fed Funds, 2-year, and 10-year notes). The median return of the S&P 500 was positive during the 1-, 3-, 6-, and 12-month periods after interest rates began to rise (see Exhibit 2).
Early stages of interest rate cycles typically favor cyclical equities. Since 1975 the first several months of a rising interest cycle have witnessed cyclical sectors outperforming defensives. In fact, the cyclical sectors of Information Technology, Materials, Consumer Discretionary, Industrials and Energy all outpaced the S&P 500 during the first three months of at least four and as many as six of the seven periods of rising interest rates since 1975. In contrast, Telecom, Utilities, Financials and Health Care beat the market on only a few occasions as rates began to rise. Note that Consumer Staples lagged the S&P 500 during the first three months of all seven episodes (see Exhibit 3).
Information Technology has the best track record of outperforming the S&P 500 during the first one and three-month periods when interest rates begin to rise. Intuitively, the market interprets higher rates as evidence of stronger growth and rewards sectors such as Information technology that are most exposed to business expansion. Conversely, Utilities and Telecom consistently underperform the market during these periods. The yield-oriented aspects of these sectors make them less appealing to investors during a rising interest rate environment.
Energy has consistently underperformed immediately following a rise in interest rates. Energy lagged the market in the first month of the rate cycle in the last six episodes. Our previous ISM business cycle analysis showed Energy to be a late cycle outperformer vs. the S&P 500. Since our sample of rate increases typically occurred during the early and middle stages of the ISM cycle it is not surprising to see a back-test show the sector lags when interest rates begin to rise. Simple historical precedent suggests risk exists to our current Overweight recommendation in Energy. However, the potential for much higher oil prices highlighted by our colleagues in commodities research supports our overweight posture.
Financials are of particular interest in the current cycle. Our analysts believe higher interest rates and a steeper yield curve represent positives for the sector assuming economic growth is not derailed.
The longer-term pattern of sector performance during rising interest rate environments is less consistent and appears to depend on the source of higher interest rates (inflation vs. growth). The S&P 500 index rose over the course of the entire tightening cycles but sector performance was differentiated based on core inflation. Defensive sectors led the market when both interest rates and inflation rose while cyclical equities outperformed when rates rose without an inflation impulse.
Kostin's full presentation:
Charts That Matter 3.31