Video Update: Why the Stock Market Is Obsessed With Interest Rates

For the past few decades, many investors were nothing short of obsessed with interest rates.

It makes sense. Stocks’ and bonds’ sensitivity to rates meant they mattered more than a lot of other economic factors.

Today, we’re in a far different environment than we were even one year ago.

The Fed is indicating it’ll keep raising interest rates – meaning high yields on bonds, making them popular places for income investors to park their cash. But rates’ relationship with the broad market isn’t the same as it used to be…

In today’s video update, Chief Analyst Adam Galas will fill you in on how interest rates have evolved, what they mean for the market, and – most importantly – what the Fed’s decisions will mean for our Fortress Portfolio.

Click the image below to watch the video or scroll down to read the transcript.

Happy SWAN (sleep well at night) investing,

Brad Thomas Editor, Fortress Portfolio

Welcome, Fortress Portfolio members, to another weekly video update.

As I promised last week, today we're going to briefly discuss why the stock market is so obsessed with interest rates.

Of course, in the last decade, that's pretty much all that mattered.

What's the Federal Reserve (Fed) going to do with rates? What are long-term rates doing?

Interest rates were all that mattered.

Well, the reason for this is that essentially various different asset classes, both stocks and bonds, have various different kinds of interest rate sensitivity.

And basically, what that comes down to is what percentage of an asset's future cash flow or dividends is getting paid up front versus a long time in the future?

For example, with tech and other kinds of growth sectors, such as communications and health care, most of the cash is in the future versus low-interest rate sensitive sectors, such as financials, energy, and materials, where most of the cash flow is up front.

So what does that actually mean?

Well, the easiest way to think about interest rates these days is to think back to the last decade. When interest rates were at 0, bond investors and savers using things like high-yield savings accounts were basically earning nothing.

So if you needed income, you had no choice but to take on more risk by buying things like junk bonds or more dangerous ultra high-yield stocks such as popular BDCs or Closed-End Funds, CDFs.

Well, now we live in a very different world. Thanks to higher inflation, we now live in a world where you can get good yield on bonds, and savings accounts yield as much as 4% and, in some cases, 4.5%.

And of course, as we've been discussing in recent weeks, interest rates still could potentially go much, much higher.

How much higher?

Well, according to the bond market, the Fed is likely to hike at least three more times to 5.25%. But there is approximately 25% chance that the Fed hikes four more times all the way up to 5.5%.

Now, this is a lot different than when we started the year.

That's thanks to red-hot economic data primarily in the jobs report, which we talked about two weeks ago.

But in the last three weeks, we've also seen a lot of other economic data accelerate, potentially indicating that the recession might be pushed back to the second half of the year or to 2024, or might not happen at all.

For example, the housing market, of course, fell off a cliff when mortgage rates went to 7%. Well, they recently pulled back to 6%, and something shocking happened. The housing market started to recover.

In fact, it started to accelerate upwards, even though interest rates, mortgage rates, had only fallen by 1%.

That's because there's so much demand for housing, so little supply, and 150 million Millennials and Gen Z-ers who are looking to start families. They have been ready and waiting to buy homes for the first time, that even a small decreasing rate was enough to boost housing.

Housing represents approximately 20% of the economy when you factor in things like Home Depot and Lowe's and various DIY home remodeling projects.

So what does this potentially mean?

Well, it does appear as if interest rates will go higher than previously expected.

Just to give you an idea of how significant the interest rate hike to 5.5% could be this year… A year ago, that was the worst-case scenario for such economist teams as Bridgewater and Deutsche Bank.

And one year ago, the bond market consensus was that the Fed would end the year 2022 at just 0.5%.

The Fed actually ended at 4.25%, the strongest rate hike cycle in 40 years.

So now 5.5% would be essentially the worst-case scenario, which economists previously expected would cause a severe recession and a 40% stock market crash.

But if you've noticed the stock market, although it has pulled back a bit in the last two weeks, it is certainly not crashing. And the economy isn't rolling over.

That's potentially because the economy has become less rate sensitive over time as some economists think and similarly, the concerns that the Fed's rate hikes haven't yet started to take effect.

Well, some economists think that we actually have become a lot more financialized, meaning that when the Fed hikes rates, it can sometimes filter through the economy in a matter of weeks or months, not 12 to 18 months, as was the case back in the 1960s and '70s.

For example, the Fed has hiked from 0% to 4 and 1/2%. But credit cards went from 14% to 20%, the highest ever recorded, and they went higher much, much faster.

So it's possible that the economy can simply withstand higher rates than we previously expected.

That actually makes a lot of sense if you think back to the 1990s.

Remember those times, the golden years of the tech boom, when the economy was growing at 4%, and the stock market could do no wrong?

Well, 10-year yields at the time averaged 6%. Similarly, we've seen things like the AI stock bubble, where some AI stocks went up 7X in a matter of weeks, even with interest rates at their highest level in 20 years and still climbing.

So what does that mean for your Fortress portfolio?

Well, the good news is we are very well positioned for this potential no-landing scenario.

As we talked about in recent weeks, the no-landing scenario is one in which the economy proves so resilient and so less rate sensitive than initially thought that essentially we don't get a recession at all.

In fact, the economy might not slow at all, and we just keep growing at 2% to 3%.

Now, as long as inflation keeps coming down steadily at a rate of 0.1% to 0.2%, as the Cleveland Fed currently expects, the good news is the Fed will probably stop at around 5 and 1/2%, potentially avoiding recession entirely. If inflation gets stuck at 5% or higher, then potentially the Fed has discussed going as high as 6% or 7%.

And that could potentially cause that recession we've all been expecting, but possibly not until 2024.

But what about the Fortress portfolio? How can this protect us in a higher inflation, higher interest rate world?

Well, remember, our two largest sectors are energy and finance. And remember, these are some of the lowest-duration sectors, meaning the least rate sensitive.

We've seen already China's reopening from COVID Zero, as well as Europe, recently, their economic data has been much better than expected, potentially raising the growth prospects for the entire world and the United States.

The earnings growth estimates for the US stock market have now come down to 0%, but that's a lot better than the -0.5% to 0% that analysts were expecting just a few weeks ago.

Also, because the recession could be pushed back into 2024, this means that instead of a 40% peak decline as was initially expected a few weeks ago, it might be potentially around -30%, very close to what we saw in October.

Or to put another way, basically there is a growing chance, though, of course, not 100%, that we have already seen the bottom. Now, that doesn't mean the stock market's going to go ripping upwards all year as we saw in January.

But there is a growing chance that we could see stocks trading in a sideways channel for months, or even the entire year.

Now, I should point out that a 10% to 15% correction is still likely this year.

But that's because 10% to 15% corrections are the average peak decline for the stock market since 1980, no matter what the economy interest rates or inflation are doing.

So how can Fortress do well in such a potentially high-interest rate, high-inflation environment?

Well, one, we have lower rate sensitivity. Two, remember that energy prices are holding up rather well.

Remember, we thought that the world was headed for recession. Why aren't oil prices crashing?

Simple, we've underinvested in fossil fuels for a decade. Supply is so constrained that unless we get a severe recession, oil prices aren't likely to do much.

In fact, Russia just cut its production by 500,000. And OPEC says they're totally cool with that. They like the high prices.

Guess what?

US oil companies, they love high prices too.

They're minting record cash, buybacks, $75 billion from Chevron, dividend hikes.

They're raking in the money, and they love it. So no plans to increase production.

Now, of course, we don't actually own oil companies in Fortress.

We own the midstreams, the energy and utility companies that basically have 80% to 90% of their revenue under long-term contracts. And even if oil producers ship no oil at all, they still get paid.

But this does mean that if energy prices were to go up-- and some economists do think they could go up to triple digits, as or as high as $140... It means what?

It means that the energy sector would likely be the best performing sector for the third straight year. And last year, midstream was up around 20%, in a year when the stock market fell 20%.

Now, in terms of interest rate benefits, remember our second-biggest sector is finance. We own things like Toronto-Dominion Bank (TD), which does see a modest benefit in terms of earnings from rising rates.

Now, you might be wondering, how is that possible with the yield curve so inverted?

Well, remember that the actual cost of borrowing for these companies, such as Toronto-Dominion, is not based on short-term Treasury bills. It's based on things like checking and savings accounts.

Those rates have been rising, but much slower than interest rates.

And meanwhile, remember when we talked about how credit card rates have shot up to record highs of about 20%?

That is how these companies make their money. The interest rates on the loans they're making are rising much faster than their actual borrowing costs.

So that spread, that profitability on those loans, is also rising. And as long as the economy is not in recession, default rates on those loans tend to be moderate, and they don't lose money on those loans.

But the biggest reason that I'm excited about potentially higher rates is that we own lots of insurance companies, such as Manulife Financial (MFC) and Allianz (ALIZY), the world's biggest insurance company.

Now, insurance companies are the best positioned to profit from higher interest rates.

Why?

Because their cost of borrowing is effectively zero, or even negative.

Remember, insurance companies will take in those premiums on policies, called insurance float, and they don't have to pay them out until many years later.

So they invest that insurance float into conservative portfolios, mostly risk-free bonds, which until very recently were earning nothing. Well, now they're earning very nice yields of about 4% and headed higher.

So the insurance companies’ cost of borrowing is basically fixed at zero or even slightly negative.

It is a high-quality insurance company like Allianz that generates profits on its underwriting. And then the interest they earn on their bond portfolios goes up. So as interest rates rise, that extra interest income drops straight to the bottom line.

So there you have it.

We are well positioned for a higher-inflation, higher-interest rate environment, with some of the world's best energy, utilities, and financials, all with very low sensitivity to interest rates in terms of downside pressure in a bear market.

But let's not forget that we have likely already seen the bear market bottom on October 14, 2022.

Now, why does this matter?

Because regardless of whether a bear market is caused by a recession or something else, historically, since 1949, the 12 months after the market bottoms, stocks average a 48% gain.

The lowest gains were 28% in 1987.

And the highest, not surprisingly, were after the pandemic, a 78% face-ripping rally.

So the point is that at Fortress, what we're trying to do is position ourselves for whatever happens with the economy.

If we get much higher interest rates and the Fed ends up causing a severe recession, we will be well positioned because, remember, we also have hedges from bonds and managed futures. These are the most effective hedging strategies, pretty much creating mirror image 25% gains while the market falls 25% in a bear market.

And if we avoid a recession, then earnings will do better. And our undervalued high-yield financials and energy companies, will do especially well.

Essentially, we're sitting on coiled springs. And that's why we're very optimistic. Because if the stock market does a 50% rally, imagine what coiled-spring, high-yield blue chips like what we own could do.

Once again, I'd like to request any questions you might have that I can answer in future video updates, as well as Fortress newsletters.

Just remember, I'm not legally allowed to provide individual investment advice, though I can answer questions about companies, the economy, and overall portfolio strategy.

Thank you for joining us for another Fortress weekly update video.

This is Adam Galas wishing you safe investing and a healthy, happy, and relaxing weekend.