As the stock market floundered in October, interest rates fell as well, hitting their lowest levels in over a year. There were plenty of reasons for the slide, but the Fed and the stock market were the major drivers. When equities are in trouble, many investors leave the stock market for the perceived safety of fixed income. Higher demand for bonds means higher prices, which drives down yields. The lowest levels came mid-month, with yields rebounding slightly—along with the market—in the past two weeks.
Changing interest rates affect all income investors, but since they can have a wide variety of effects, figuring out whether changes in rates are going to help you or hurt you can be a complex problem.
This month, lower rates were mostly a boon to our portfolio. The biggest beneficiaries were our utilities and REITs. Utilities benefit from lower rates because they can secure cheaper financing—at least that’s the common wisdom. You can see the “vanilla” version of this dynamic on the left side of the chart below: when interest rates (blue line) rise, utilities (orange line) fall, and vice-versa. But after the first quarter of this year, the picture gets murkier, with utilities and rates sometimes moving in the same direction.
Adding a measure of the broad market to the chart clarifies the picture a little bit, making it clear that the overall direction of the equity market is responsible for some of the times when utilities moved independently of interest rates. Below is the same chart of utilities and interest rates with the S&P 500 added in red. However, that’s not a one-to-one relationship either. Sometimes a falling market drags utility stocks down with the rest of the equities. Other times, a falling market benefits utility stocks, as investors flee riskier names for the perceived safety of staid, dividend-paying utilities.
Lastly, fears and expectations also play a major role: even when interest rates aren’t moving, fears that they will rise soon are rampant, and that can make utilities less attractive to investors.
This month, we saw a kind of perfect storm of the above factors all working in utilities’ favor. Falling interest rates also benefited our REITs, which see lower operating costs when rates are low and higher investor interest when fixed-income is offering low yields.
Going forward, interest rates are sure to start working against us again soon. Fear of a rate increase is still high, and while the Fed is being anything but aggressive about raising the base rate, it is winding down its bond-buying program. The final complication is the relationship between inflation, which would spur a rate increase, and economic growth, which would spur inflation but be good for the economy, and the stock market. I’ll leave that for another day.