Advisors may be fielding some calls from nervous clients this week.
The new trading year kicked off inauspiciously, with a global rout amid concerns about an economic slowdown in China and escalating tensions in the Middle East. Overall, it may be a challenging year ahead for advisors and their clients. And while investor attention is currently focused on global markets, China growth and energy prices, Fed tightening also remains a persistent factor for equities in 2016.
Jeffrey Saut, chief investment strategist at Raymond James, says he is "fairly constructive" about the year ahead for stocks, particularly in relation to rising interest rates. He cites history to back up his opinion: Since 1954, the S&P 500 has risen 9.5%, on average, 12 months after the first Fed rate hike.
"I think Janet Yellen is going to be true to her word," says Saut, who calls the Fed chair a "gradualist." He adds, "I think the economy's going to gather strength in 2016."
STAYING PREDICTABLE
"We think the Fed is going to keep things predictable," says Francisco Torralba, senior economist at the investment management division of Morningstar. Although he says he thinks the policy will follow a fairly certain path, Torralba also notes, in contrast to Saut, that there are too few historical instances of Fed tightening to use it as an indicator of stock price direction.
"The expectation at the moment is of a very shallow, drawn-out period of interest rate hikes, with a cumulative tightening of probably less than three percentage points over the next two years," he says. Torralba says we should picture the expected increases as "the gentlest slope we have seen since at least the 1950s."
While Torralba sees a slope, many investors may picture a vanishing punch bowl. But the Fed hasn't really taken away the punch bowl; with rates still very low by historical standards, you might say that the central bank has slightly watered down the punch.
How stocks in general and in specific sectors will react to higher rates is the subject of some debate. "When you are able to increase rates, it means you have an economy healthy enough to sustain growth," says Brian Kazanchy, a managing partner at RegentAtlantic Capital, a wealth management firm in Morristown, NJ. Because the Fed waited so long to increase interest rates, and they remain low, he says, "It's actually somewhat stimulative."
He expects consumer-driven companies to benefit from Fed actions, but stock prices for many of them "have really been bid up already," Kazanchy says. "You're going to see certain areas like financials really benefit from the increase. They can earn a better spread on their assets."
Chris Bennett, a senior analyst at S&P Dow Jones Indices, is more cautious on the prospects for that sector. "We're going to have to wait and see how much of that is priced in already," he says.
DIVIDENT DOWNER?
Bennett does see potential problems for dividend-paying stocks. He notes that telecom and utilities sectors "may see a little bit of trouble as rates go up." As rates rise, observes Bennett, "the value of future dividends is going to naturally decrease."
Kazanchy also sees "dividend-driven stocks" as a potential weak area, and cites telecom issues as a prime example.
But Connor Browne, one of the managers of the Thornburg Value Fund, has a slightly different take on winners and losers in a rising-rate environment. "There has been a lot of stuff in the equity market that is of value only because interest rates are very low," he says, noting that low rates push people who are reaching for yield further out on the risk curve.
Browne says Santa Fe-based Thornburg has had a difficult time finding good value in what the firm calls "extensive defensives," which include some consumer staples issues, big U.S. telecoms and utilities with high yields. He expects that the adjustment in Fed policy will change the types of stock that will be attractive to investors. Rising rates "ought to create a good environment for active managers," he adds.
His fund is positive on a number of sectors. "We think there are opportunities in health care," says Browne, who also favorably cites deep-value groups including energy and IT hardware. And he would not rule out lower-yielding issues in the consumer staples and utilities sectors.
While higher rates often push down dividend payers, this cycle "may be a little different because rates are so low," he says. One factor to look for, says Browne, is a company's "ability to grow a dividend over time."
Browne says the relative stability of the 10-year T-note from early November through the end of 2015 is evidence that the investment world took the Fed's tightening move in stride. "I don't foresee problems," he says.
He adds, "The Fed will continue to tighten only as long as economic fundamentals support continued action."
For years, nervous pundits have declared that the Fed's long period of near-zero short-term rates would be a recipe for inflation. Kazanchy sees that as a minor risk. "With commodities having tanked, it's hard to have a lot of concern right now about major inflation," he says.
MULTIPLE FACTORS
Bennett sees numerous elements influencing both the economy and future Fed actions. "We're going to have to take into account a lot of factors," he says, including inflation, commodity prices and the health of international economies, especially China. "The big factor going forward is the price of oil," he adds.
Kazanchy agrees. "I don't think that the Fed rate-hiking cycle is the biggest news going on right now," he says. "I think the collapse of energy prices is still the number one factor when we're looking at company earnings."
Kazanchy observes that the decline in the energy sector essentially wiped out 2015 earnings growth for the S&P 500. The silver lining, he says, is that comparisons will be easier this year. He cites the consensus estimate of 9% earnings growth for U.S. companies in 2016.
Factors aside from Fed tightening also count more in Torralba's view. "I think the Fed is a sideshow when it comes to the outlook for U.S. equities," he says, noting that an appreciating dollar and the economic sluggishness in the rest of the world don't bode well for U.S. corporate profits.
That's because companies in the S&P derive about half of their revenues from outside the United States, observes Torralba. A rising dollar means those revenues and earnings are worth less to American companies.
In addition, he notes that low energy prices are a drag on the S&P. That sector depends on high or rising energy prices for profits. "That doesn't seem to be in the cards," he says.
Torralba says he is puzzled by forecasts that U.S. corporate profits will rebound in 2016. Margins are high and it will be difficult to keep them growing, especially in light of expected higher labor costs. "It seems there is very little upside for profits and revenues," he concludes.
Saut cites a weakening economy in China and the proxy conflict between Saudi Arabia and Iran as two examples of factors that could provide headwinds for stocks in 2016.
Even though he expects stocks to rise this year, Kazanchy says he knows that not all equities will move in lockstep. What should advisors do if their clients' solid portfolio holdings decline?
"If you've got companies that you believe in and you think are fine," he advises, "I would stick with them."
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