By Parke Shall
It is finally starting to look as though we are going to see a rate hike in March. Goldman Sachs increased their odds of a rate hike to 90% to end the week last week and hawkish talk from Janet Yellen seemed to confirm that view, despite other Fed presidents being all over the map with their comments late last week as well.
The market seemed to like the news, actually. At several points during the week when dovish comments were made by some Fed presidents, the market found itself slipping. When Yellen spoke about rate hikes, the market actually ticked up a slight bit, indicating that market participants are ready for a rate hike.
We admire the ambition of the market, but we also need to deliver a crude reality: both the market and interest rates can't continue to go up at the same time. While higher rates definitely are a positive for banks and a couple other financial components that make up the indices, their overall effect on the markets is going to be negative. There is no doubt, there is only a question of how long the market can stay irrational about the relationship it has with interest rates. We are not saying that the market won't go up any further from here, All we are saying is that the relationship between the market and interest rates gets stretched further and further every time the Fed hikes in the market moves higher.
Why do we believe the market eventually is going to move lower?
As long as the Fed continues to raise rates, here is our basic thesis for why the market should move lower:
1. First and foremost, people will start to gravitate away from the risk of equity markets in towards the safety of other types of depository accounts for yield. When rates start to move higher, savings accounts and certificates of deposit once again start to actually produce some yield that is worth investing in. When this happens, money starts to move out of the equity markets.
2. As money starts to move out of the equity markets, rates are starting to go up on consumer debt and corporate debt. This is going to start many consumers and corporations in a cycle of deleveraging in order to make that their priority. This means less spending, less research and development, lower quality of product and ultimately less consumer demand and less earnings. People and businesses all get crunched together as the aftershock of rates raises the cost of capital for everybody and as a result, consumer spending declines.
3. Delinquencies and defaults will start to creep up. We have already seen delinquencies and defaults in the automobile sector and in consumer credit start to tick higher over the last 6 to 12 months. This is going to be a trend that we believe will continue as we get further and further away from the bull market that started in 2009. Usually it takes about seven or eight years for this cycle of credit to turn over and it has now been about eight or nine years, so we are waiting with bated breath.
Where To From Here: 2 Different Paths
The only question now remains whether or not there is some semblance of any economic theory left in the system as we know it here in the United States. There are many from the old school who could make a reasonable argument that economic theory, even Keynesian theory, doesn't even apply anymore because the numbers are manipulated and the Federal Reserve takes its cues from the stock market. All that we can do is look at the purest indicators of economic data that we have access to. We look to see what products cost every time we buy them. We look to see where interest rates land on a historical basis over the course of 20 years and not just over the last few years. All of the data that we see leads us to one of two situations:
First, rates begin to rise significantly and cause a shock to the markets that has not been seen for decades. We have gotten so accustomed to a lower rate environment that spending and debt repayment adjustments that would need to take place in order for the United States to deal with the effects of a 5% rate in hikes would be catastrophic. Equity markets will crash and in the market will go through a long overdue rebalancing and correction that would shift economic indicators and pricing toward a more realistic monetary policy.
Second, rates stay low and we continue to create an enormous debt bomb in the country that either explodes through our currency devaluing or through loss of confidence in central banking and our economic system. Here, it is also a catastrophe but one where the central bank may not be able to do anything to help. We predict in a situation like this we would see QE4 with unprecedented bond buying and potentially negative interest rates. These "remedies" will only do far more harm than good and would create a massive economic crisis at some point down the road.
Both of these situations don't end well for equity markets. The first situation is one that we prefer, as we need to simply take a dose of the medicine here and realign our markets and our economic system. We have recovered enough and the time is now. Should we move down the second path, we are going to see a far different type of catastrophe; the one where people will be glad that they own precious metals (and maybe even Bitcoin).
Before the election was completed, we wrote an article talking about why financials would be the only sector that we would invest in. We stated this was because rates were going to rise. We also acknowledged the same risk we talk about today,
First, financial stocks would benefit significantly from a rise in interest rates. While interest rate hikes certainly seemed like they were off the table after the United Kingdom voted to leave Europe, global markets have since rebounded on the idea that Central Banks would basically do anything they need to in order to maintain flourishing equity markets.
Of course, nobody thinks of the consequences of what this could mean, people simply go out and buy equities first and ask questions later. With markets continuing to rise, it is not out of the question that the Federal Reserve will start to once again contemplate a rate hike for September of this year. Whether or not it happens is another story. If it does happen, however, banks will stand to benefit the most, as the financial sector will likely get a boost and the rest of the market will likely blow off some steam and pull back a little bit.
We also stated that we thought financials were going to receive a boost, no matter which of the two Presidential candidates were elected and no matter which way the Federal Reserve decided to move with regard to interest rates.
We remain bullish on financials if you absolutely have to get long stocks right now.
But one thing is for sure, we don't believe that both interest rates and the stock market can keep moving higher. The euphoria that we see in the market leads us to believe that the coming correction, no matter what the catalyst, is going to be swift and it is going to be powerful. We continue to reduce our long exposure accordingly and continue to add hedges.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.