The Fate of Interest Rates: Prepare for Cuts or Consistency

by Tom Kennedy, CFA® | Jun 27, 2019

With trade rhetoric and geopolitical risks driving volatility, there’s no sign of a summer slowdown in U.S. fixed income and equity markets. In the short term, headlines spotlighting issues from the Iranian conflict to weak employment data have provoked significant one-day moves, while optimism on the trade front sparked a market rally this month. Following a tumultuous first half of 2019, the summer presents a great opportunity to reassess and strategize portfolio allocations for the remainder of the year

As an overwhelming number of economic and political factors continue to influence market activity, it can be difficult to determine which risks to prioritize during the investment decision-making process. In this post, we will highlight the single underlying economic factor most likely to influence U.S. markets and investor decisions for the rest of 2019: interest rates. 

Federal Reserve (Fed) policy will continue to be in the crosshairs in 2019, as discussions surrounding rate cuts gained momentum in recent months, and the central bank’s June meeting left the door open for a rate cut before year-end. The Fed has made it clear that rate decisions are largely data dependent, and they are willing to take a step back and analyze economic projections before determining a course of action.

Despite the Fed’s dovish change in posture, we anticipate that speculation over interest rates will drive significant volatility and impact returns in the months ahead. Over the past year, both equity and fixed-income returns have been comparable — with the Barclays U.S. Aggregate Bond Index and S&P 500 Index returning 7.5% and 7.8%, respectively. But as markets move back toward a low-interest-rate environment, where can we expect the most lucrative returns?

Unfortunately, there’s no straightforward answer. With stocks close to fully valued, subdued equity returns can be expected going forward. Despite muted expectations for the stock market, there are pockets of opportunity in specific sectors, highlighted by divergent returns to interest rate sensitive sectors. For example, real estate, consumer staples and utilities have been the top performing sectors over the last year and could continue to outperform in a low interest environment as investors flock from low yielding bonds to their relatively higher dividend yields. On the other hand, the energy and material sectors have suffered from these low inflation, low interest rate conditions. Interest rates have been the biggest differentiator in determining sector leadership within equity markets this year.

While low interest rates and declining inflation have delivered attractive bond returns, we have tempered expectations for fixed-income markets. Late-cycle dynamics and slowing economic growth are driving fixed income, so it’s critical to maintain the quality of your portfolio. Both corporate and consumer debt levels are at all-time highs, while high-yield and low investment-grade triple-B rated debt has grown faster than the fixed-income market as a whole. These positions could add unanticipated risks to portfolios, so we recommend venturing cautiously when seeking extra income from lower quality bonds. Despite this risk, fixed income is delivering modest, positive real returns to our clients, and serving as a stabilizer in your portfolio amid market uncertainties.

As the debate over interest rate cuts continues to play out in Washington and the media, we believe that the Fed should hold rates steady. While a rate cut would help mitigate the impact of inflationary pressures on both equity and fixed-income markets, the Fed would be wise to monitor the unstable tariff conditions and wait for a trade resolution before making a policy decision. In the meantime, we are proactively evaluating our investments and developing a game plan for the possibility of a lower-interest-rate future or more of the same.