Recalibrating Your Portfolio for Higher Interest Rates
By Seth Van Brocklin
- Will the Fed keep raising rates until it causes another financial crisis?
- Inside: Top myths about what rising rates mean for precious metals.
The Federal Reserve has introduced a new risk factor for financial markets in 2016: that of higher interest rates. Rate hikes were all talk and no action for most of 2015. But the Fed finally acted in December – not to save the economy, but to save itself.
The Fed can always be counted on to pursue its institutional interests. It faced a serious credibility problem if it failed to hike. After all, it spent months talking about an improving economy, allowing them to begin “normalizing” rates.
The economy didn’t actually improve by most of the Fed’s own gauges. Although official employment numbers showed slight improvement, actual workforce participation rates remain near multi-decade lows. Commodity prices plunged as global demand weakened. Year-over-year inflation is running at 0.5%.
These are not conditions that normally call for tightening. Most of the rest of the world, led by Europe, moved to drive interest rates lower and pursue stimulus. By taking the opposite approach, the Fed is playing a dangerous game with the economy and markets.
Fed-Inflated Financial Assets Now Carry Greater Risk
If rate hikes trigger another financial crisis, the central bank could abruptly reverse course. Former Fed chair Ben Bernanke said recently, “I think negative rates are something the Fed will and probably should consider if the situation arises.”
Negative rates? Yes, that’s now considered as a serious, sensible policy proposal by central bankers. Negative rates are already being implemented in Europe. And if the Fed realizes it misfired by attempting a hike, it can reverse course and drop rates below zero.
The Fed’s past easy-money policies have caused financial assets to artificially inflate. And the stock market to diverge from the real economy. According to famed bond fund manager Bill Gross, “Much like time is relative to the speed of light, the faster and faster central bankers press the monetary button, the greater and greater the relative risk of owning financial assets.”
His investment advice? “I would gradually de-risk portfolios as we move into 2016: less credit risk, reduced equity exposure, placing more emphasis on the return of your money than a double digit return on your money.”
Myths about Rate Hikes and Hard Assets Dispelled
Let’s look at a widespread belief that higher interest rates are bad for all investments. They’re bad for bonds because bond prices move inversely to yields. But remember that the Fed only controls the short-term rate. A small increase in short-term rates doesn’t necessarily cause long-term rates to rise. But as Bill Gross suggests, it may heighten worries about credit risk.
Higher rates are often thought to be bad for the stock market as well. But typically, at least during the early stages of a rate-raising cycle, stocks tend to hold up pretty well. An analysis by Allianz Global Investors found that since 1983, the S&P 500 averages a return of 9.9% during periods when the Fed is hiking.
It’s typically when the Fed is frantically easing to try to rescue the economy that the stock market is crashing. The Fed is more of a follower than a leader when it comes to the stock market. It “rescues” markets as they are crashing rather than before. The Fed’s failed track record of preventing market crashes is virtually unblemished by any successes.
As for hard assets, including the safe-haven play of gold, it’s widely believed they do poorly in an environment of rising rates. It seems intuitive that higher rates on cash would make hoarding
precious metals less attractive. But that intuition is empirically wrong. When the Fed last embarked on a series of rate hikes, from June 2004 to June 2006, gold prices gained 75%!
Allianz Global Investors finds that commodities are the best performing asset class during Fed rate-hiking campaigns. Commodities as a group have advanced an average of more than 25% during such periods. If the natural resource sector rebounds this year, the Market Vectors RVE Hard Assets Producers (HAP) exchangetraded fund could easily post gains of greater than 25%.
Precious Metals Outlook for 2016-17
So what does the Fed’s decision mean for precious metals markets this time around? Probably not as much as most analysts seem to think. Wherever gold and silver prices head in 2016, the underlying fundamentals of supply and demand (both paper and physical) will have more influence than short-term interest rates.
Current spot prices are set in the futures markets by banks and other big institutional players. But whether today’s low prices are sustainable will be determined in the actual physical market. The physical silver market is expected to join the platinum and palladium markets in going into annual supply deficit in 2016. The supply of newly mined gold also figures to be crimped as
unviable operations shut down.
Supply destruction could be the biggest story of the year in the mining sector – and more broadly, in the entire resource extraction industry.
Demand for industrial commodities is highly correlated with ebbs and flows in the economy. However, demand for precious metals can rise amidst a bad economy as investors seek safe havens. The bull market in demand for physical bullion charged ahead in 2015. There’s a good chance that a bull market in prices will follow in 2016.
Last year, the U.S. Mint saw a record number of orders for its silver American Eagle coins. The Mint set a new all-time high in sales of Silver Eagles. And that is despite the fact that it was unable to fulfill demand at several points during the year. Late in the year, the Mint also became overwhelmed by demand for Gold Eagles – selling out of all its 2015-dated coins weeks before year’s end.
Low prices are attracting buyers at the same time that they are dis-incentivizing and disabling new mining supply from coming online. There’s a good chance the metals markets will find a major bottom later this year, if they haven’t already.
Energy Investing Outlook for 2016-17
The financial media spent most of 2015 obsessing month after month over the potential for a 0.25% increase in short-term interest rates. It seems that “Fed watching” has become the favorite pastime of most economics reporters. But the biggest real-world economics story of 2015 was the precipitous drop in oil prices.
By mid-December, crude oil had fallen all the way down to $35 per barrel, matching the crisis lows of 2009. In the December Independent Living, Lee Bellinger spelled out some reasons why he believes cheap and plentiful oil is “here to stay.” My question is: For how long? And how cheap is “cheap”?
In theory, there is enough exploitable oil and gas in the ground in North America to last us for decades – for the rest of most of our lives. That’s the good news. Lee is correct in noting that the reserves exist, and that we now have the technological capability of extracting them. But that doesn’t mean we are entitled to enjoy $35 oil in perpetuity.
Oil prices below $50 per barrel make many fracking, deep sea, and other high-cost oil production projects uneconomic. Rig counts dropped rapidly in the second half of 2015 – indicating future production is being taken offline. In the meantime, OPEC has artificially flooded the market with lowercost oil in a deliberate attempt to drive out marginal players and maintain its market share.
I don’t see oil below $50 as being fundamentally sustainable. The longer oil prices stay below that level, the more supply destruction will occur. And the more supply that is taken out, the higher prices can go in the future.
Oil and other commodities never simply stabilize at levels economists think are justified by supply and demand fundamentals. Instead, prices get pushed and pulled violently and unpredictably in futures markets. Oil prices are always on the verge of either dropping by 50% or doubling. The one thing they won’t do is stay at $35 per barrel.
Prices might trade in a narrow lateral range for a few weeks or a few months. But as an investor you need to be thinking about the next big directional move. Will oil prices fall 50% to below $20 a barrel? Or double to $70?
I’d bet on crude oil doubling – not necessarily over the next year, but perhaps over the next few years. If I’m right, then the energy sector represents one of the best investment opportunities now available in terms of risk/reward. There is still risk, especially in the fracking and drilling companies. The large integrated oil companies, including ExxonMobil (XOM), Chevron (CVX), and ConocoPhillips (COP) are less risky. They have managed to keep their dividend payments flowing amidst the recent downturn in the sector.
Other energy markets, including natural gas, coal, and uranium, face similar challenges and opportunities. The eventual upside in these sub-sectors could be as spectacular as the downside has been brutal.
Alternative energy such as solar and wind can’t compete with cheap oil and gas on an economic basis. But alternatives continue to enjoy political support. If you want to hedge against a Hillary Clinton-led Democrat sweep in the upcoming election, the PowerShares WilderHill Clean Energy ETF (PBW) is one way to do it – at least in theory. In practice, alternative energy will remain a speculative space. It will struggle to scale as long as fossil fuels are comparatively so much cheaper and more reliable.
The One Hedging Strategy that Works Consistently
How can you as an investor protect yourself from downside market volatility? It’s a difficult task, especially in a low interest rate environment. Cash still yields close to nothing. Bonds have risks of their own.
There are various hedging strategies you can employ. Most of them you should avoid. Short selling, inverse funds, long/short funds, managed futures…these and other hedges either require precise timing to work or are so inefficient over time as to do no better than act as dead weight on a portfolio.
The highest-risk place to hedge (or more aptly, speculate) is in the options market. Getting involved in options is a lot like gambling at a casino. The house always wins and individual speculators are more likely to lose the more they play.
With one exception. That exception is the so-called “covered call” or “buy-write” strategy.
An Option to Extract Extra Income from Assets without Incurring Extra Risk
Covered call option writing entails selling options on stocks owned for additional income. You get immediate income. The buyer of your option incurs all the risk. Your only risk is that, since the buyer acquires the right to buy a security at a specified strike price, you are forced to sell. You’ll still be selling at a profit, but you’ll be limiting your upside to the strike price.
Due to the transaction costs and tax complications, covered call writing may not be practical for all investors. Fortunately, there are now several specialty funds that execute the covered call strategy.
The Gateway fund (GATEX; GTEYX) is one of the oldest and largest. It invests in S&P 500 stocks, then writes call options on the S&P 500 index. Though positively correlated with the S&P 500, it’s significantly less volatile. It can actually show positive gains during a choppy sideways market due to income generated from option sales.
There are now multiple ETFs that employ the covered-call strategy for other markets. There are even covered-call instruments for gold (GLDI) and silver (SLVO). Whereas most gold and silver ETFs pay no interest (since gold and silver bullion pay no interest), a covered-call strategy converts gold and silver into income-generating assets.
Here are 10 exchange-traded products that use covered call option writing to generate extra income:
• AdvisorShares STAR Global Buy-Write (VEGA)
• CBOE S&P 500 BuyWrite Index ETN (BWV)
• Credit Suisse Gold Shares Covered Call ETN (GLDI)
• Credit Suisse Silver Shares Covered Call ETN (SLVO)
• First Trust High Income (FTHI)
• First Trust Low Beta Income (FTLB)
• Horizons S&P 500 Covered Calls (HSPX)
• Horizons S&P Financial Select Sector Covered Call (HFIN)
• Recon Capital NASDAQ 100 Covered Call (QYLD)
• S&P 500 BuyWrite Portfolio (PBP)
You should be bullish on the underlying assets before buying a covered-call fund or attempting to execute the strategy yourself. You can still lose money in a bear market. But because you’ll be generating option premiums as income, you’ll lose less. And in a sideways to uptrending market, you’ll make money.
The real beauty of this hedging strategy is that it’s also viable as a long-term buy-and-hold strategy.