The Federal Reserve (Fed) is almost certainly going to raise interest rates in December, but what’s less certain is what comes after that – will 2019 see three rate increases or four?
My base case is that it will be three, because inflation has been very minimal so far in . The growth rate in house prices has slowed, which detracts from inflation, so the Fed might not have to be too aggressive. Also, wage inflation has been muted. If we start to see wage pressure then Treasury Inflation-Protected Securities (TIPS) will become attractive, but for now we don’t see inflation taking off.
But if the Fed does opt for a fourth rate hike, I believe there could be serious repercussions. Higher rates act as a tax on the economy, raising the cost of capital for companies and making expansion more difficult. If the Fed pushes rates too high, it could put us in a recession.
We’ve already seen equity investors bracing for such a possibility.
Recently, equity markets have been going though a valuation correction. Prior to 2016, tech stocks in particular had been issuing debt because they couldn’t access their foreign earnings without incurring large tax consequences. That’s supported the capital value of existing debt.
Over the past decade, companies across several sectors have borrowed money to fund share buybacks and dividend payments, as well as mergers and acquisitions. These activities have made their equity investors happy, but we’ve reached a point where the market appears more concerned about debt-heavy capital structures.
Now several companies are taking corrective action. For example, Anheuser Busch Inbev has cut its dividend in half in an effort to save $4 billion, which it plans to put toward deleveraging. Similarly, Comcast and IBM have each announced an end to their share buybacks.
Credit investors are happy to see these decisions.
Support for Treasuries
I believe the midterm election results are somewhat supportive of U.S. Treasury Bills. If the Republicans had maintained their House majority and added a Senate majority, President Trump would have had a blank cheque. President Trump is not a traditional Republican, in that he has demonstrated that he is no deficit hawk. In my opinion, a quiescent Legislative branch could have unleashed a flood of new Treasury debt.
A Democratic majority in the House represents a greater potential for gridlock, which may limit new issuance and support existing U.S. Treasury Bill values.
At the moment, the economy appears to be doing well, but risks are getting greater every day, so I think this is a decent entry point to the fixed income market.
With higher rates on the horizon, we’ve added floating rate securities over the past few months. Most people think that equates to bank loans, but some investment grade bonds also pay a floating rate. That’s been my focus for two reasons: we avoid taking on additional credit risk; and our investment grade bonds are not callable as bank loans are.
At the end of the day, we’re trying to be that “boring bond fund” that could provide some stability to your portfolio. We’re not loading up on credit risk because that’s highly corelated to equities. If an investor wanted exposure to equities, they’d buy equities.