This month’s Federal Reserve policy meeting could signal the end of an era. Policymakers may decide to raise interest rates for the first time since the Great Recession, marking the end of an era of ultra-low rates that has defined financial markets for almost seven years.
Although signs of slowing global economic growth have decreased the likelihood of a September rate increase, many economists still expect policymakers to take action at least once this year as the labor market improves. The Fed has kept its benchmark rate at close to zero since late 2008 to help revive the economy.
As well as helping the economy, those low rates have been great for financial markets. But if interest rates start rising, will that automatically reverse the stock market’s momentum?
Jim McDonald, chief investment strategist at asset manager Northern Trust, explains what he expects to happen with interest rates, how that will impact financial markets, and what investors should, or shouldn’t, do. Answers edited for clarity and length.
Do you expect an interest rate increase this year? We do expect a rate increase this year. The Fed is itching to start to get off zero interest rates, so they will move this year. They are nervous that they don’t have any dry powder to deal with an increase in financial markets or economic volatility. They can’t really cut rates any more and the market would respond negatively to (more) quantitative easing. They want to get rates up, so that in the future, if they want to cut rates, they have that option.
How high could interest rates go? Over the next year, it could be two interest rate hikes. So, they would get up to 50 basis points (0.5 percent) and then they have to hang out. Because along with the Bank of England, they will be the only central bank that is raising rates. The economy is just not that strong.
What should investors do in response to higher rates? There is absolutely no need for panic around the Fed starting to raise rates. Some people are concerned about it, but this is an extremely studied event and the market is rarely disrupted by an event that is overanalyzed. And this has been overanalyzed. The recent volatility in the market has been tied to China. And secondarily, it’s been tied to people saying “Jeez, you know what? The major central banks really don’t have a lot of ammo if we do get into a significant downturn.” It’s that aspect of monetary policy that has been of concern. It’s not worries about a 25 basis point increase, which, in the scope of everything else going on, is immaterial.
Which sectors perform best in a rising rate environment? Typically the financials would be the standout performer in that environment. Financial stocks have been hurt by the low interest rate environment, and they should be good performers with a higher rate environment. So they are the number one example. But we’re not overweight financial stocks right now because we think that the rate increases are going to be relatively minor.
What’s your favorite sector in the current environment? Health care is one of our top recommendations, and that’s because the fundamentals in health care are just so good. And they won’t really be impacted by a small increase in interest rates.
