As of 2015, the Federal Reserve has maintained an interest rate policy that has kept the federal funds rate near zero for over six years. These low interest rates, coupled with multiple rounds of quantitative easing, have helped pull the economy out of the last recession. This successful strategy has been used as guidance for other recessions in the eurozone and Japan.
However, the United States has never had a zero-rate policy for this long and has never implemented a quantitative easing program prior to 2009. As a result of these new strategies, there have been many unintended consequences in the capital markets. Now that the Federal Reserve intends to increase the federal reserve rate, it is important to understand what consequences and effects the change in policy will have on stock portfolios.
Fed Fund Rate Hike's Effect on Equities
The unprecedented monetary and fiscal policies over the past six years have had large effects on the U.S. equity market. Domestic equities have tripled since their March 2009 lows. Corporate earnings doubled over the past six years, from $417 billion to $1.04 trillion. Total capitalization of the S&P 500 Index grew from $6 trillion in 2009 to $19 trillion in 2015.These sharp increases in equities, corporate earnings and capitalization are due in large part to the low interest rates and quantitative easing (QE), which forced capital into financial assets, pushing stock prices up and pushing yields on fixed-income instruments lower. From here, some expect an increase in interest rates by the Federal Reserve will be bad for the equity markets.
However, this might not be true. There have been six rate increases since May of 1983, and the average return of the S&P 500 Index after the initial hike was 14.4%. Past performance shows that an increase in the federal funds rate does not have much of a negative effect on people's stock portfolios.
Dividends and share repurchases were roughly $900 billion in 2014 and are estimated to reach $1 trillion in 2015. The 10-year Treasury yield is close to 2.2%, and the yield on cash is close to 0%, both of which compare favorably with the current earnings yield on the S&P 500. These are all signs that equities should continue to perform well in any investor's stock portfolio, even with an increase in interest rates.
Fed Fund Rate Hike's Effect on Alternative Investments
The performance of alternative investments will have an effect on an investor's stock portfolio if that portfolio contains hedge funds and equity index funds. During quantitative easing, hedge fund returns were disappointing when compared to the performance of equities. With the U.S. serving as the risk market of choice for investors during QE, a large amount of risk-on money flowed into equity index funds. This made stock picking for equity index funds very difficult and hurt overall performance.However, performance turned around for both hedge funds and equity index funds in January 2015. As of the middle of 2015, the HFN Fund Aggregate Index, a representation of alternative investments, was up 3.23% and the HFN Equity Hedge Index was up 5.12%.
This compares to a performance of 2.6% percent for the S&P 500 Total Return Index over the same period. While it is hard to predict whether trends like these will continue with federal funds increases, it shows that alternative investments perform well enough to be part of an investor's stock portfolio.
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