What Goes Down Must Come Up
What goes down must come up. Interest rates are still at historic lows, but we expect them to rise this year and next. But why, and by how much? What will be the impact on consumers and on the real estate market? What should investors do? Let’s explore the answers to each of these questions.
After a three-year period when the Federal Reserve cut interest rates to their lowest level since 1958, Americans have become far more willing to load up on debt, and banks have become far more willing to let them.
The economic recovery has been fueled, so far, largely by low interest rates.
Household debt climbed at twice the pace of household income from the beginning of 2000 through 2003, according to data from the Federal Reserve. Bedazzled by low interest rates, Americans took on $2.3 trillion in new mortgage debt during that period ? an increase of nearly 50 percent. Consumer credit, from zero-interest auto loans to the much more expensive debt on credit cards, climbed 33 percent, rising to $2 trillion in 2003 from $1.5 trillion in 2000.
Alan Greenspan, the Federal Reserve chairman, like the Trends editors, has repeatedly argued in recent months that rising household debt poses few problems. Fed officials note that the financial position of American households is, in some respects, stronger than ever. The most important point is that the value of household assets ? from resale prices of homes to the size of stock portfolios ? has increased even faster than debt.
In fact, the collective net worth of American households is now higher than it was before the stock market bubble burst four years ago.
And thanks in part to lower interest rates, monthly debt payments consume a smaller share of monthly income today than in late 2001. Although there are pockets of financial stress among households, the sector as a whole appears to be in good shape.
But household debt could soon start to put the squeeze on consumer spending. Fed officials have made it clear that they must eventually raise rates. The main question is whether the move will come this summer or be delayed until early next year.
Not only have low U.S. interest rates been a factor in the U.S. recovery, but they’ve played a more important role in the continued explosive growth of the “foreign investment driven” Chinese economy than domestic Chinese monetary policy.
In recent weeks, China has taken a few modest steps to slow its allegedly overheated economy. It has raised reserve requirements, clamped down on cement, steel, and aluminum projects to curb excess development, and implemented some land-use rules to slow industrial growth.
Of course, much of China’s boom has been financed primarily by international capital inflows that completely bypass the Chinese banking system. As Lawrence Kudlow points out in a May 3, 2004 report, “It’s as though there are two Chinese financial systems: One is local, which will be affected by government-imposed credit restraint. The other is global, especially after China’s admission to the World Trade Organization. That money will be unaffected by local decrees.”
Meanwhile, in recent weeks the U.S. dollar has reversed course and appreciated by roughly 6.5 percent on one widely-followed currency index. This means that the Chinese yuan is appreciating along with the dollar.
Currency appreciation amounts to a tightening of monetary policy in both countries. As currency values rise, increased consumer and business purchasing power will slow price increases. But, as Kudlow explains, U.S. commodity and stock markets are overreacting to a very mild dose of restraint.
Already gold and copper prices have fallen nearly 10 percent. Wheat has dropped nearly as much. Steel scrap has fallen over 19 percent.
It’s important to note that the logic behind this shift resides not in any sense of serious inflation on the part of the Fed, but rather in its observation of strong economic growth. And while bond rates, commodities, and other indicators suggest the early presence of modest inflation in the system, the Fed doesn’t look at those. They pay more attention to the output gap, discussed by Kudlow in the Wall Street Journal.
As Fed governor Ben Bernanke keeps telling us, inflation cannot rise because the economy is still suffering an output gap. This means the actual level of today’s inflation-adjusted gross domestic product is below a theoretical GDP level that would have been achieved if the economy were growing to its fullest potential.
Bernanke, a former Princeton economics professor, is certainly right about the output gap. Since the onset of the 2001 recession, the economy has cumulatively fallen behind its long-run potential by $4.4 trillion.
This calculation assumes trend growth in GDP of 3.5 percent per year, which is the historical record of the U.S. economy since 1947. For the latest data in last year’s fourth quarter alone, potential GDP was about $11 trillion. The actual level of GDP came in at $10.6 trillion. The difference, or output gap, is therefore roughly $400 billion.
Because economic resources are underemployed, budgetary consequences have been severe. When the actual level of GDP falls below a hypothetical level of fully-employed economic potential, the U.S. fiscal position deteriorates.
Actual economic growth trends above or below full employment GDP are the single biggest factor in budget swings between surplus and deficit. In terms of joblessness, Greenspan has suggested that full employment would equate to a 4 percent unemployment rate. Today’s rate is 5.7 percent. That unemployment gap of 1.7 percentage points represents underutilized labor resources. It is a shorthand version of the overall GDP output gap problem, which also includes underemployed business resources.
By producing and employing below the long-run potential of the American economy, a sizable shortfall of income and wealth occurs. Consequently, tax receipts from wages and salaries, corporate profits, and capital gains also fall well short. It is this above all that worsens the budget picture.
Assuming an average tax rate of roughly 20 percent, which is the rule-of-thumb used by most government accountants, personal and business tax revenues in the last quarter fell about $80 billion short of potential, or $320 billion at an annual rate. That is about two-thirds of the $480 billion budget deficit estimated by the Congressional Budget Office.
So it is clear that the under-employment of the economy and the wide output gap between actual and potential GDP are the major deficit-causing factors in to-day’s fiscal picture. However, since President Bush’s across-the-board tax cut implemented retroactively last year, economic growth has quickened significantly.
If these new tax incentives are permanently left in place, as the President proposes, then the gap between actual and potential U.S. economic growth will narrow rapidly. As a result, so will the budget deficit. Tax incentives to generate a more rapid return to full employment throughout the economy are the most vital deficit-reducing policy that government can make.
Importantly, a full-employment American economy with 3 percent long-term growth and 4 percent unemployment in the years ahead will produce a new cycle of budget surpluses beginning in 2011. Because the Congressional Budget Office economic baseline falls well below full employment, with only 2.8 percent yearly growth and 5 percent unemployment, the long-range budget outlook appears much worse than is actually the case.
In all likelihood, U.S. economic efficiency would be maximized with a consumer price trend of roughly 2 percent per year. Permitting inflation to rise beyond that would threaten the national goals of full employment and fiscal balance.
Assuming Fed Funds will be at 1.75 percent by year-end 2004 and 3.5 percent at year-end 2005, versus 1.0 percent today, we’re faced with a number of threats and opportunities for consumers, investors, and managers. Here’s how the Trends editors expect it to play out:
In the past few years, our collective experience has been that even the threat that interest rate hikes may be around the corner causes markets to tumble. Consider, the 123-point drop in the Dow Jones Industrial Average on April 20, when Greenspan told the Senate Banking Committee “It’s fairly apparent that pricing power is gradually being restored.” The ability of companies to raise prices translates into inflation, and inflation coincides with higher rates, which can choke off business growth and, naturally, the prices of stocks and bonds.
The problem with all this “groupthink,” however, is that it’s often wrong. Everyone’s focused on the market going into a tailspin the moment the Fed starts raising rates. What people forget is that the uptick in rates is actually a natural consequence of the fact that things are getting better. As things get better, this is what is supposed to happen.
We’d be more concerned if the Fed wasn’t increasing interest rates. In fact, stocks can and do rise along with interest rates. Other factors, notably corporate earnings, are as important as interest rates ? or more so. And even within supposedly interest rate-sensitive sectors like financial services, investors can make money as rates rise.
What’s often misunderstood, however, is how much rate hikes hurt ? and when. According to a study by Ned Davis Research, the period after an initial rate hike typically is a better-than-average environment for stocks. If anything, the anticipation tends to be worse than the event, especially if the Fed acts in a measured way when it begins tightening. In a study of 22 initial rate hikes since 1917, Davis found that the Dow went down an average of 1 percent in the month before a hike ? and it went up nearly the same amount the following month.
Although rate hikes aren’t necessarily to be feared, maximizing your returns in such an environment requires some adjustments to your portfolio. As suggested by Fortune magazine, here are four ways to ride those rising rates.
1. Rethink your approach to bonds. Even though the bond market has held up longer than many experts thought it would, if rates rise, bond prices will move in the opposite direction from their yields. One fund that plays rate hikes is the ProFunds Rising Rates Opportunity Fund. The strategy of the managers is to bet against the latest 30-year Treasury bill by regularly selling short those bonds. The investment isn’t a sure thing, since it requires rates to rise, but the fund’s price has spiked by 10 percent since mid-March as long-term rates have risen. 2. Seek out companies that benefit from a strengthening global economy. Rising rates tend to affect companies that need the markets for cheap capital. So they tend to benefit companies with strong balance sheets and healthy dividends. GE’s dividend currently yields about 2.6 percent, which is more than passbook savings. Its stock ? which has basically treaded water for the past year, far underperforming the S&P 500 ? trades at a slight discount to the index’s overall valuation of about 20 times expected 2004 earnings. 3. Don’t overlook the opportunities in the booming finance sector. A rising-rate environment is a good time to look for banks that focus on businesses, not consumers. Because commercial loans tend to move in concert with the prime rate, lessening the interest rate impact on the lender, look for banks with a higher than average percentage of commercial loans. 4. Avoid anything related to mortgage rates. The early stages of rate increases, however, could have the opposite effect: As mortgage rates go up, the frenzy to own a home at still-low rates could grow stronger.
What else can you expect? We offer the following forecasts:
First, we expect interest rates to rise by no more than one percent by the end of 2004. Look for a half point increase in June, and another half point in August, bringing the Fed Funds rate to two percent before the year is out. This is very much in accordance with the Eurodollar curve, which calls for a 2.00 percent rate by the end of 2004. If we follow this projection, the rate is going to end up at 3.75 percent by the end of 2005. This makes sense when looked at as “normalization” ? the Fed can’t maintain a 1 percent policy rate in a 5 percent economy. [Editor’s Note: After we recorded the audio portion of this month’s issue, we surveyed our economic panel in light of the latest market developments. Their consensus was for a more aggressive forecast of Fed tightening this summer, than we originally reported.] This adjustment should put the fed on target to prevent any return of disruptive inflation while keeping the recovery on track.
Second, these rate increases will not end the boom in either the U.S. or China. Instead, by restraining inflation expectations, the prosperity cycles in both countries are likely to be prolonged, not halted.
Third, rising interest rates will deliver a sharp jolt to some consumers. People with home equity loans will see their monthly payments climb almost immediately. Adjustable mortgages will increase more slowly, because many borrowers lock in rates for several years. But monthly debt burdens will eventually rise.
Fourth, housing prices could drop sharply in some overheated markets like New York and Southern California, where many homes have doubled in price over the last five years. People who bought their homes with no money down could find themselves unable to sell without owing money to their lenders.
References List :
1. To access the report "U.S. ? China Money," visit the Kudlow and Company website at: www.kudlow.com 2. The Wall Street Journal Online, April 16, 2004, "Output Gap," by Larry Kudlow. ⓒ Copyright 2004 by Dow Jones and Company. All rights reserved. 3. Fortune, May 3, 2004, "How to Ride Rising Rates," by Adam Lashinsky. ⓒ Copyright 2004 by Time Warner, Inc. All rights reserved.