• Investment Management

Could a Fed Rate Hike Actually Boost Stocks?

Any rise in U.S. interest rates this year is likely to do more good than harm to equities, says Morgan Stanley senior equity portfolio manager, Andrew Slimmon.

It’s the final stretch of 2016, and the stock market has resumed its obsession with rates. The Federal Reserve increased its key federal funds rate for the first time in a decade last December, and now investors are eyeballing this coming December for the next.

Typically, the Fed’s tightening moves are bad news for stocks. Rising rates usually strengthen the dollar against other major currencies, which can weigh on exports and the international earnings of U.S. companies. It also makes bonds more competitive as an alternative to stocks.

This time is different, says Andrew Slimmon, senior portfolio manager for Applied Equity Advisors at Morgan Stanley Investment Management. He expects a strong fourth quarter for U.S. equities, partly because any rate rise is likely to boost price-to-earnings (P/E) multiples, rather than harm them. “The market might see a pullback between now and the end of the year, but it should not be meaningful or lasting,” he says. “There are indicators that suggest the market is healthy and the economy is actually on the cusp of accelerating. I think a rate rise could actually boost earnings multiples.”

Focus on Sales Growth

This is a radical idea, especially when S&P 500 Index, a benchmark of the broader U.S. stock market, is trading at a P/E multiple of 17, which compares with an historic median multiple of 13.8. Slimmon argues that any revenue improvement could boost P/E multiples, after years of corporates propping up profits via cost cutting or share buybacks or other strategies. “The market is likely to place a higher multiple on better quality earnings boosted by actual sales, than the multiple that’s been placed on earnings supported by buybacks and other corporate financing strategies,” says Slimmon.

S&P 500: Price-to-Forward Earnings, Ended Aug 31, 2016

Source: ClariFi, Thomson Reuters and Morgan Stanley Research.

Besides, if the next rate hike is a quarter of a percentage point, as the market consensus expects, then that’s hardly reason for panic. “It would bring our total rate rise to 50 basis points so far this cycle. In a typical rate-rising cycle, the Fed increases rates 27 times, for a total of 6.67%,” he says.

The market also has good reason to interpret the first several rate hikes as a much welcomed move back from the brink of zero.  “All the handwringing about ‘normalization’ of monetary policy in the U.S. is overdone,” says Slimmon. “Normalizing rates could give investors confidence that the Fed is acting rationally. We need to get it over with and move on.”

Eventually, higher interest rates could take their toll on stock prices. “But it’s only in the late stages of the cycle, when we are close to recession and when the bond yields get competitive with equities that you tend to see P/E multiples go down,” says Slimmon. That appears to be a long way off: The S&P dividend yield, a basic measure of stock performance, was around 2.15% in September, compared to the 1.6% yield of the benchmark 10-year Treasury bond.

Another reason Slimmon is bullish on equities: Earnings in the fourth quarter aren’t expected to be nearly as bad for key sectors, such as energy, as they were in the final quarter of 2015, reflecting the steep decline in oil prices—from $45 a barrel at the end of 3Q 2015 to a low of $26 in February 2016.

“Year-on-year profit numbers for certain sectors, such as energy, materials, and industrials, could get much easier, given where oil prices are today, says Slimmon, adding: “The market trades on forward earnings projections. It’s all about the future.” 

“Old Economy*”Sectors Performing Better in 2016 vs. 2015

Source: Haver Analytics, Morgan Stanley Wealth Management GIC. Note: S&P 500 US old economy sectors are Industrials, Materials, Energy; S&P 500 US new economy sectors are Discretionary, Staples, Healthcare.

* “Old Economy” defined as Energy, Industrials, Materials.

Past performance is no guide to future performance and the value of investments and income from them can fall as well as rise. Indices are unmanaged and not available for direct investment. They are shown for illustrative purposes only and do not represent the performance of any specific investment.

Growth stocks may offer the greatest value, according to Slimmon. For the most part, areas of the market that have soared in value this year—defensive high-dividend paying sectors, such as utilities and consumer staples—may be less attractive going forward.

Slimmon’s only caveat to all of this is any sudden surge in the dollar against other major currencies. “But I don’t expect this to happen unless the Fed is very aggressive on increasing rates.”