by David Maddux, CEO | CIO

We sent the following note to clients on September 13th

Are Lower Interest Rates a Good Thing?

Seasons may be changing.  Sometimes we can detect the shift from one season to another, like maybe it is less hot in the early mornings and evenings.  Although it still feels like summer is in full swing, with the midday heat in Tampa at 90+ degrees and “feels like” readings of 103+, we know that climate conditions will change sooner than later.  The hope around my house is that we get a taste of fall by Halloween.

The economy, industries and markets have their own cyclicality as well, but they do not match to any particular timetable.  Sometimes these changes are noticeable, but most can only be identified in hindsight.  It is with some hesitation that I even dig in here.

We have an election bearing down on us and stock market price volatility picked up last month, but the catalyst for considering a seasonal change is that the Federal Reserve has recently signaled they will begin cutting interest rates as early as this month.  As well, the absolute level of the higher interest rate environment this year has presented an opportunity to adjust a balanced portfolio (stocks and bonds) more conservatively.

Reminder – owning stocks broadly over stretches of time has been a great opportunity, but they are a logically fickle asset class in the short term and exhibit normal behavior of a 10% sell off about once every year, 15% about every two years and over 20% about every 3.5 years (Ned Davis Research).  A posture of benign neglect is useful for ignoring the normal noise that comes along, but it is also useful to periodically reassess, especially when valuations change.

Two years and ten months ago the Federal Reserve signaled they would begin increasing interest rates.  The surprise was that they ended up increasing them much faster than expected.  The result has been an interest rate environment much higher than what prevailed on average over the prior 15 years.

We have perceived that change toward higher interest rates to be a net positive one, even if over-leveraged investors, businesses and consumers were likely to experience some stress.  2022’s declining stock and bond market was no fun for most anyone except an all-cash saver, but we think the ability for individuals and institutions to invest cash in risk free bonds/CDs for a reasonable interest rate again to be a good thing.

Historically interest rates have been much higher than the 0%-1% range they were held to since 2008 and with inflation popping up into the 5%+ range in 2021/2022, we also assumed the Federal Reserve understood the economy as being able to digest an interest rate at 3% or higher.  It has been bumpy in different areas getting here, but it seems like the domestic and global economies have managed to shift from the “zero-bound” and in some countries <0% interest rate world to a historically normal, positive interest rate world.  That is a sign of health and connects back to the logic of economic basics.

Otherwise, if the economy needed a near 0% interest rate to be okay, something was not okay.

We did not expect the interest rate rise to happen so quickly, but per past writings, we took advantage of that by reaping the benefit of patience with the bond allocation.  We had allowed maturities since the COVID panic of 2020 to roll over into short term treasury bills and money markets and began buying bonds again in 2022.  That process took about a year and then we extended the average maturity further in late 2023 and again earlier in 2024.  Our model portfolios* today hold an average of a four year maturity (some bonds come due this next year, while others in four to seven years) and a yield to maturity in the high 4% range (some are 4-ish% and some are 5-ish%).

So now what?

If higher interest rates have ultimately been okay for the economy, publicly traded companies and their stock prices, what does a lower interest rate foretell? 

Logically, lower interest rates will lower the cost of capital, which should eventually be a positive for corporate earnings, but is the Federal Reserve behind the curve again (pun intended for investing nerds – the interest rate curve is a reference to the relationship of a short term interest rate to a medium term one to a long term one) as they were in 2022? 

For example, the main reason why the 2022-2023 increase in rates was faster than expected is that inflation was coming in hotter than the Federal Reserve expected.  A reflexive process kicked off as they tried to play catch up via the “Fed Funds Rate” (a daily rate) compared to the swiftly rising 2-year treasury rate that kept moving higher in anticipation of the Fed raising rates to catch up. 

Is the new shift in policy to interest rate cuts something to be excited about or cautious about in the near term?  We cannot know for sure, but think it is reasonable to consider a change of seasons.  For example, different measures show the COVID liquidity injection to people’s checking accounts has run its course and maybe the higher rate environment has begun to “bite” with higher interest rates on credit cards (delinquencies highest in 20 years – St. Louis Fed), auto loans, home equity loans, etc as Chapter 11 bankruptcies are the highest in more than a decade (Cypress Capital, August 2024). 

Our assumption is that a methodical interest rate cut in a “soft landing” scenario would work out fine, but if the Federal Reserve needs to cut quicker and deeper than they have signaled, it would mean they are behind the curve again, which would imply soft revenue for businesses, declining profits or even losses, in the short term.

Stocks and Posture

Like the swift interest rate move, we did not expect stocks to recover their 2021 highs as quickly either, which they did toward the end of 2023.  However, these types of setbacks are allowed for and we held the equity allocation intact, as well as were able to do some net buying of stocks for most clients in 2022 (generally those not on planned distribution schedules) as part of our re-balancing process.

This year we have used the all time high in most stock indices as an opportunity to “over-balance.” “Re-balancing” is bringing allocations back into alignment by selling what has gone up to buy more of what has gone down or not gone up as much.  Over-balancing is selling a bit more and in this case we have been cutting the stock portion back to ~90% of target allocations or ~10% “under-weight” for most clients.

For example, if a portfolio has a target of 60% stocks we have sold enough to get to that 60%, but also an additional 6% (10% of 60%) and parked it in a treasury bill coming due on November 7th, 2024 and earning 5%+.

The opportunity cost is that stocks broadly keep working higher over the next year or so and a portfolio does not make as much as it could have, but the optionality is that if they retreat for any number of reasons, there is less capital at risk and we have an initial “portfolio budget” to work with to start buying stocks again to bring back into alignment.  I believe the optionality is worth the tradeoff.

Conclusion

Capital market conditions generally feel the same as they have been for a while where bad news doesn’t matter and any price breaks in stock indices are quickly covered over and forgotten.  A real outcome can be that the Federal Reserve may end up threading the needle for a soft economic landing, which would be a positive. 

The Federal Reserve will likely lower interest rates in the foreseeable future and the narrative around the stock market seems to be that lower interest rates are better.  But if the lower interest rate narrative shifts from being better to bad because of a lagged effect that higher rates are starting to bite, then stock market conditions likely become hostile.

Bottomline – stock prices are at all time highs, valuations are stretched on the over-valued side, earnings are okay but not great, dividend yields are near all time lows and cash is paying 5%, while five year risk free bonds still pay 3.6%.  I think cash and bonds both add a nice benefit to a liquid portfolio these days.  In the 14 years leading up to 2022, they were sources of stability in geo-political stress, but did not offer any interest to speak of.  They currently offer both interest and stability.

We are long term optimistic about the economy and stock prices and are not anchored on a change happening, but rather are focused on preparation, patience and flexibility.

*This letter is tonal in nature.  We use model portfolios and apply consistent thinking, but each client has a separate portfolio and there are many reasons for exceptions, like tax basis, planned distributions, heirloom holdings, preferences, size of the account, etc. 

Brightwater Advisory, LLC is an SEC registered investment adviser* with its principal place of business in Tampa, Florida.  This letter contains general information pertaining to our advisory services. The information is not suitable for everyone and should not be construed as personalized investment advice. This letter contains certain forward‐looking statements (which may be signaled by words such as “believe,” “expect” or “anticipate”) which indicate future possibilities. Due to known and unknown risks, other uncertainties and factors, actual results may differ materially from the expectations portrayed in such forward‐looking statements. There is no guarantee that the views and opinions expressed in this note will come to pass.

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