March 18, 2022

Rising Rates Environment Weighs Down Growth, High Yield Funds

by Jack Fischer.

On Thursday, March 17, U.S. broad-based equity markets ended the day in the black for the third straight session—Nasdaq (+1.33%), S&P 500 (+1.23%), and DJIA (+1.23%). Equity market participants continue to be hopeful that Russia-Ukraine peace talks will continue to progress. On the U.S. fixed income front, the big news this week came from the Federal Open Market Committee’s (FOMC) decision to increase interest rates. This past Wednesday, the FOMC hiked rates by a quarter percentage point; while expected, the move officially signals the start of a monetary tightening cycle. It is widely forecasted that there will be six more hikes this year with three coming in 2023. The fixed income market has been preparing for such a move for a while now, with the Treasury yield curve already essentially flat.

Why raise rates now?

The Federal Reserve’s dual mandate is to achieve maximum employment and long-term price stability. With the job market returning to pre-pandemic levels, the focus has been toward cooling inflationary pressures.

In order to curb broad-based price increases that eat away at savings and consumer purchasing power, the Fed has historically increased rates. Increasing the Fed Funds rate directly affects other rates such as auto, credit card, and mortgage rates. By making borrowing dollars more expensive, consumers and producers adjust their spending habits which in turn leads to price adjustments.

Looking at the above chart we see that the Fed decreased the Federal Funds rate in order to jump-start the American economy out of recessionary periods, and by doing so asset prices increase to basically a breaking point. In these recessionary periods, asset prices have regressed until the Fed has lowered the rate to a point that frees up the American consumer to open their pocketbooks back up.

The recession brought on by COVID-19 is fundamentally different than prior downturns, but excessive stimulus, consumer demand, and unforeseen choke points in the global supply chain have brought about similar economic issues. With the Fed raising interest rates this past Wednesday, we have already seen a significant increase in mortgage rates. Freddie Mac said mortgage rates have increased to more than 4% for the first time in almost three years. The expectation for this increase has already cooled off the housing market—the National Association of Realtors (NAR) reported that home sales (existing) fell 7.2% to their lowest total since August 2021.

One generally accepted, forward-looking indicator for a recession has been the 10-two Treasury yield spread. When this figure becomes inverted, market participants are no longer incentivized to invest in longer-dated securities since short-term issues provide the same yield and similar risk. The 10-two Treasury yield has fallen 59.5% so far this year and is currently hovering at 0.31%. As we approach zero, the wider market will prepare for a market contraction that normally takes place about three years afterward.

Lipper Classification Flows

In January, the top three Lipper classifications were Multi-Cap Core Funds (+$11.3 billion), Loan Participation Funds (+$10.5 billion), and U.S. Government Money Market (+$9.5 billion). These three classifications represent equity diversification, prediction of future rate hikes, and a strategic reallocation toward short-term securities. Top outflows came from Large-Cap Growth Funds (-$16.5 billion), High Yield Funds (-$11.5 billion), and S&P 500 Index Funds (-$9.8 billion). Growth and high yield investments struggle in a rising rates environment. Growth (especially technology) issues have to now price in a higher borrowing cost into their heavily debt-ridden financials. High-yield bonds become less attractive when an investor can get a similar yield on the open market for less credit risk.

In February, the top three Lipper classifications were International Income Funds (+$31.8 billion), S&P 500 Index Funds (+$30.9 billion), and Large-Cap Value Funds (+$8.3 billion). Investors in February gravitated toward financials while diversifying their equity holdings. Now that interest rates have increased, financial institutions will be able to charge more to their customers to borrow. Savings rates, unfortunately, do not normally increase as quickly.

Just this past week, the top three inflows came from U.S. Government Money Market Funds (+5.4 billion), Multi-Cap Value Funds (+$3.1 billion), and Commodities Precious Metals Funds (+$1.3 billion). The top three outflows from equity and fixed income classifications were High Yield Funds (-$1.6 billion), International Large-Cap Growth (-$1.5 billion), and S&P 500 Index Funds (-$1.5 billion). Inflation not only eats away at sitting cash but also fixed-rate coupon payments. Commodities have and will continue to be a strong attractor of flows within the coming weeks.

Check out more weekly flow trends here.

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