While most central banks around the world are lowering interest rates, the United States Federal Reserve decided yesterday to begin raising them. So we’re now officially in the divergent policy environment that I’ve spoken about for well over a year now.
Straight away, I’ll say this divergent environment should treat stock pickers well. In particular, actively-managed investment strategies that are able to look outside the stock market – and play both the long and short sides – should be able to outperform a passive buy-and-hold strategy.
Of course, the Fed’s decision is still fresh. So it’ll be a while before we can truly assess how investors react… and determine the winners and losers of tightening policy.
But we can find clues by looking back to 2013, when then-Chairman Ben Bernanke began warning that higher rates were on the horizon.
Bernanke’s message sent a wave of volatility through global markets. It unleashed divergent market trends, essentially separating the (likely) “haves and have-nots” of the post-zero-interest-rate-policy world.
Let’s take a look at how global markets performed between May and September of 2013 – the Taper Tantrum.
Treasury Yields Skyrocket
Naturally, the mere suggestion of the Fed’s desire to tighten sent Treasury yields higher. But the magnitude of the move was extreme by historical standards.
Between May 2 and September 6, the 10-year Treasury yield went from 1.61% to 2.98%. That’s a massive, 80% moonshot in about four months.
And it was truly an unprecedented move. Going back 50 years, I can’t find one instance of a larger increase in such a short amount of time.
Of course, bond markets around the world sold off in unison during this period. But a closer look shows there were some flavors of bonds that took Helicopter Ben’s warning harder than others. Take a look…
The sell-off in U.S. Treasury bonds shows a clear trend: long-term (TLT, far left) suffered more than medium-term (IEF, middle), which suffered more than short-term (SHY, far right).
This is interesting because it shows bond investors might have bought into the Fed’s message, believing that a hot U.S. economy, and perhaps even inflationary pressure, was just around the corner.
U.S. Stocks Beat Foreign Stocks
The Taper Tantrum also created divergences between global stock markets.
U.S. stock indices were the clear winners. While foreign stocks, particularly emerging-market stocks, didn’t fare quite as well.
Take a look…
First, it’s interesting that the Russell 2000 (IWM, far right) and Nasdaq 100 (QQQ, right next to it) were the top-performing stock indices through the Taper Tantrum. This suggests that stock investors’ knee-jerk reaction was not: “Oh crap, they’re taking the punch bowl away!”
Instead, Bernanke’s warning reminded investors that U.S. stocks were the best game in town. Investors piled in, betting that that outperformance would continue for a while longer (and indeed, it has). A majority of U.S. sectors, too, beat foreign stock markets during this time – showing the preference for U.S. stocks was widespread.
Meanwhile, as U.S. indices climbed between 4% and 10% higher, emerging-market stocks (EEM) lost nearly 6%. In particular, Brazil’s stock market lost 14%… and India’s was down 17%.
Now let’s take a look outside the stock market.
Higher Borrowing Costs, Without Inflation?
Rate-sensitive investments reacted swiftly to Bernanke’s warning.
The Utilities sector and real estate investment trusts (REITs) are notoriously dependent on debt financing. So as they braced themselves for an environment of increasingly higher borrowing costs, investors lowered their return expectations from these rate-sensitive niches.
Utilities stocks (XLU) lost 9% during the Taper Tantrum and REITs (VNQ) fell 12%. Take a look…
Interestingly, gold prices (GLD) also fell during the Taper Tantrum. That’s a bit counterintuitive – since the Fed’s message should have prompted investors (particularly gold bugs) to worry about inflation, which would have given gold prices a boost.
Instead, lower gold prices suggested that deflation, not inflation, was still the dominant trend – despite what the Fed was saying.
And finally… volatility.
The Taper Tantrum sent the Volatility Index (VIX) 22% higher. This shows that investors were either pessimistic about future market returns… or that they had no clue what to expect from a post-punch bowl market.
Either way, the sudden jump in volatility acted as confirmation that investors had become fixated on the Fed’s every move – a theme that (unfortunately) continues to dominate global markets even today.
Will This Time Be Different?
There’s no guarantee that markets will react to yesterday’s Fed decision, over the next four months, the same way they reacted during the four-month Taper Tantrum in 2013.
For one, we’re in a different place now than we were then. U.S. stocks are more overvalued. Foreign stocks are more beaten down. And, oh yeah, a nasty little oil crisis popped up… along with a rapidly deteriorating junk bond market.
What’s more, we might see investors “buy the rumor, sell the news.” Meaning, they might respond to the rate-hike becoming “news” differently than they reacted to it being a “rumor.”
I hate to say it, but this time might be different.
Rather than assuming markets will follow the exact Taper Tantrum course, I’ll be watching closely for opportunities amongst the winners and losers of the Fed’s tightening cycle.
Adam O’Dell, CMT
Chief Investment Strategist, Dent Research