What Top Value Investors Think About Fed's Interest Rate Decision

Market volatility has increased as the Federal Reserve’s decision on whether to raise interest rates for the first time in almost a decade approaches this week. Many value investors, who typically remain relatively impassive in the face of market vagaries, nevertheless have been addressing the noteworthy event.

The following is a collection of guru interviews and shareholder letter excerpts that discuss how they view interest rates, what they expect the outcome of a Fed move to be and whether the macro decision will change their investing in any way.

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Howard Ward, director of GAMCO Investors’ growth equity business who has worked with Mario Gabelli (Trades, Portfolio) for 21 years, told GuruFocus Tuesday:

“Basically, a single 25 basis point increase in the lower range of the Fed Funds target is not a game changer for investors. We would not be reacting to such a change. If you were making the case that the Fed would be raising rates multiple times over the next year then that would warrant additional thought. That is not in the cards, however.

The initial lifting of rates from 0 bound to 25-50 basis points would seem to have its most immediate impact on financial institutions, both for their ability to eliminate roughly half of their money market fund fee waivers as well as signaling the start of a longer term process of normalizing their net interest margins (on the presumption that the whole yield curve is going to move up). This has been widely anticipated and a number of investors have already made some adjustments to their financial services exposure in order to benefit from rising rates, as have we. That is, a Fed move is bullish for financials, albeit somewhat discounted.

In short, there are good arguments on both sides of the debate about the Fed making a move now. If they do move, they will signal they are going to sit pat for an extended time. Consequently, investors should not overreact to a Fed move as it is relatively minor and is wide discounted to happen at some point this year. Unfortunately, the absence of a tightening move for 7 years has turned this into a major media event, perhaps a bigger media event than financial event.”

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Bill Nygren, Oakmark Funds, told GuruFocus Tuesday:Â

"Higher rates won’t alter our view of the market as a whole because we are already using a required return that is 100bp higher than we would use if we believed bonds could remain at such a low level. Not until rate increases exceed 100bp in intermediate term bonds would further increases start to impact our values. We probably have even a little more cushion than that because if rates on intermediate term bonds increase by more than 100bp, we believe it is likely that inflation expectations will increase beyond the current 2%, and we will need to also increase our revenue growth estimates, partially offsetting the negative effect of a higher discount rate.

When it comes to how higher rates change our relative value estimates, we have also already incorporated a 100bp increase in rates into our current earnings forecasts. As an example, most of our 2017 forecasts for financial company earnings are higher than consensus because we assume rates will be higher than they are now while consensus generally assumes rates will be unchanged. If rates go up more than 100bp, we will have to increase our earnings estimates for banks and other financials, which will increase their relative attractiveness.

So, we believe our portfolio is positioned to benefit from higher interest rates, and we are anxiously awaiting the return to a more typical environment."

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Bill Ackman (Trades, Portfolio), Pershing Square Semiannual 2015 Letter:

“We select investments in companies that meet our extremely high standards for business quality. We primarily invest in businesses that are simple, predictable, and free-cash-flow-generative with substantial barriers to competition and strong pricing power due to brands, unique assets, long-term contracts, and/or dominant market position. We vastly prefer businesses that have limited exposure to macroeconomic factors by generally avoiding companies that are highly exposed to commodity prices, material changes in interest rates, and other extrinsic factors we cannot control. We focus on large capitalization, North-American-domiciled businesses that earn the substantial majority of their profits in North America. We often hedge large non-U.S. currency exposures in the portfolio. We seek investments that trade at a discount to intrinsic value as is, and an even wider spread as optimized.

The result of this approach is a portfolio comprised of the highest quality collection of businesses that we have ever owned, managed by the strongest management teams that we have worked with, all trading at substantial discounts to intrinsic values. These businesses are generally conservatively financed, often investment grade or soon to be, generate substantial amounts of recurring free cash flow, typically don’t need access to equity capital to survive or thrive, and often return capital to shareholders through buybacks or dividends. As a result of these characteristics, the intrinsic value of the businesses we own is not particularly correlated with equity or credit market volatility.”

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Jeff Auxier (Trades, Portfolio), a speaker at the 2016 GuruFocus Value Conference, told GuruFocus in an Aug. 7 interview:

"The macro environment is important because you’re looking at supply and demand. There are stocks that look like bargains, like the banks did back in 2008. But if you dug deeper, they were borrowing heavily. Washington Mutual was borrowing to pay their dividends. Look at what’s happened now to commodities; we were calling for that. We warned about this 118-month boom up through 2011 in commodities, which was preceded by a 113-month boom in housing and a 114-month boom in telecom media. It really helps to pay attention to big supply and demand, so when prices are high, inputs come in. Copper was sitting at three times the cost of production, and we said most commodities can only trade barely above the cost of production. Sure enough, you’re seeing that now, and it’s kind of the opposite of 2011. Freeport-McMoRan (FCX, Financial) has dropped from 60-12.

Our mandate is to compound clients’ money and to do that, you follow two of Buffett’s rules: First rule is don’t lose your capital, second rule is don’t forget the first rule. Those two rules have been the savior for my career since 1982. But doing that requires a very dedicated research effort to not only look at each entity in its entirety, but also to look at supply and demand. That still doesn’t mean we’re focusing on predicting markets or predicting interest rates. We’re looking at areas where we can get hurt, and that means going back to examine history. Albert Einstein once said that compounding was man’s greatest invention. We don’t want to violate that, and that means through this research effort, we can mitigate risk by looking at all the variables and inputs."

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Brian Rogers (Trades, Portfolio), Second Quarter Shareholder Letter for T. Rowe Price Equity Income Fund:

“We expect steady, albeit modest, economic growth in the second half of the year. Earnings growth should be similarly modest as the impact of lower oil prices and the strong U.S. dollar should continue to weigh on S&P 500 earnings. While record corporate profit margins have had a positive effect on earnings, we believe that there will be some downward pressure on margins as the economy continues to grow and cost pressures rise. Investors continue to focus on every statement from the Federal Reserve, which is suggesting that it is likely to raise rates sometime in the second half. The Fed will evaluate both global economic conditions and the underlying tone of the U.S. economy as it considers its next move. With equity valuations neutral at best, we have modest expectations for stock price gains in the second half of the year. As always, we hope to be pleasantly surprised if our expectations are exceeded.

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John Hussman (Trades, Portfolio) - The Beauty of Truth and the Beast of Dogma:

“The dreaded quarter-point of horror

With regard to a possible quarter-point hike this week in the amount of interest that the Fed pays banks on idle excess reserves, our view – frankly – is that it doesn’t matter. From a longer-term standpoint, poor stock market returns and the likelihood of 40-55% market losses from the recent peak are already baked in the cake. From a shorter-term standpoint, what matters for market outcomes is not Federal Reserve policy directly, but the effect that any policy move would have on investor risk-seeking or risk-aversion. Historically, the best measure of those risk preferences has not been Fed action itself but the uniformity and divergence of market internals across a broad range of individual stocks, industries, sectors, and security types, including debt of varying creditworthiness.

Across the pond, our friend Albert Edwards at SocGen strikes the right note, I think:

“The clamour for the Fed not to enact the long-awaited ¼% rate hike next week is growing by the day. Misgivings come not just from reputable mainstream commentators, but now also the World Bank has repeated the IMF’s recent words of caution in advising delay. What a load of nonsense! My esteemed colleague Kit Juckes characterizes the current consensus thinking as ‘If the Fed hikes, pestilence, plague and never-ending deflation will follow.’ Well even those like me who see a deflationary bust awaiting think the Fed should hike next week – because the longer you leave it, the bigger the financial market excesses become, and the bigger the risk of financial dislocation and global recession ensuing. Have we learned nothing from the 2008 Great Recession? Just get on with it!”

With respect to the economy, we know that a quarter-point means nothing, given the weak correlation between policy rates and subsequent output, employment and inflation. From a purely economic standpoint, my impression is that the main effect of hiking interest rates would be to draw zero-interest currency into the banking system in the form of even more idle reserves. We’re already seeing indications of an economic slowdown, but the impact of a quarter-point hike on that dynamic is meaningless. The economic slowing we’re seeing here – which as yet isn’t strong enough to warn of recession – was already developing in February (see Market Action Suggests Abrupt Slowing in Global Economic Activity) and based on declining new orders, falling backlogs and rising inventories, is still underway.

The real problem isn’t what the Fed may do, but the ultimately unavoidable consequences of what the Fed has already done. The cost of reckless Fed-induced yield seeking will likely be felt first in the financial markets as previous paper gains evaporate, while defaults on excessive low-quality covenant-lite credit will emerge over the course of the economic cycle, and the impact of malinvestment will be to limit productivity and economic growth over the longer run. This is all rather inevitable except in the eyes of those who haven’t watched and memorized a dozen adaptations of the same movie.

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The immediate question isn’t whether a quarter-point hike will have an economic impact, but whether a quarter-point hike will be the “event” that provokes increasingly risk-averse investors to act on selling plans that are already being contemplated. Alternatively, perhaps the Fed will decide not to hike, which might be taken as a kind of “easing” move by the central bank. That’s typically been good for at least a short-lived boost to speculative morale, but as I observed in February (see Expect a Decade of 1.7% Portfolio Returns from a Conventional Asset Mix), keep this in mind:

'First and foremost, the response of the equity markets to Federal Reserve easing (and much other news) is conditional on the risk-tolerance of investors at the time, which we infer from observable market action such as internals and credit spreads, among other factors. Quantitative easing ‘works’ by creating default-free liquidity in an environment where that liquidity is viewed by investors as an inferior asset. That is, if investors are risk-seeking, as inferred from the uniformity of market action across securities, sectors and asset classes of all risk profiles, then yes – Fed easing will tend to support further advances in stock pricesregardless of the level of valuation. On the other hand, once investors have shifted toward risk-aversion, overvalued markets become vulnerable to abrupt free-falls and crashes, and monetary easing is not materially supportive for stocks because default-free liquidity is desirable.

Again, as I noted in The Line Between Rational Speculation and Market Collapse, investors should remember that the Fed did not tighten in 1929, but instead began cutting interest rates on February 11, 1930 – nearly two and a half years before the market bottomed. The Fed cut rates on January 3, 2001 just as a two-year bear market collapse was starting, and kept cutting all the way down. The Fed cut the federal funds rate on September 18, 2007 – several weeks before the top of the market, and kept cutting all the way down.

What will matter significantly for investors is the condition of market internals, credit spreads, and other risk-sensitive measures in the event that U.S. economic activity begins to further reflect the downturn that is already evident abroad. It is that evidence of investor risk-preferences that will determine the proper response to any change in Fed policy.'

In short, my view is that activist Fed policy is both ineffective and reckless (and the historical data bears this out), and that the Federal Reserve has pushed the financial markets to a precipice from which no gentle retreat is ultimately likely. Similar precipices, such as 1929 and 2000, and even lesser precipices like 1906, 1937, 1973 and 2007 have always had unfortunate endings (see All Their Eggs in Janet’s Basket for a review). A quarter-point hike will not cause anything. The causes are already baked in the cake. A rate hike may be a trigger with respect to timing, but that’s all. History suggests we should place our attention on valuations and market internals in any event.

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Please see periodic remarks on the Fund Notes and Commentary page for discussion relating specifically to the Hussman Funds and the investment positions of the Funds.”

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Meridian Funds (Trades, Portfolio), Annual Report 2015:

“Our financial holdings are mainly high-quality companies that will benefit from higher interest rates. Interest rates have been near historic lows for an extended period of time, a condition that has hurt the earnings of many banks and certain financial markets, and the idea that interest rates will eventually rise is largely a consensus view. We are 'bottom-up' investors and believe that our competitive advantage lies in fundamental analysis of out-of-favor companies. As such, we do not make large investments based on macroeconomic factors unless we believe that our bottom-up research has given us insight into macro trends that run counter to the prevailing market view. In this case, we have no such contrarian viewpoint about rates, per se, but our fundamental analysis of how rates may improve the earnings power of financial services companies suggests to us that the market is not accurately discounting this possibility. This situation has created an asymmetric investment opportunity in financials that we find compelling. Consistent with our overall investment strategy, within the financial sector, we focus on companies that we believe may not only benefit from a higher interest rate environment, but also are out of favor due to company-specific challenges that may be better suited to our fundamental investment process.

One such recent investment is MetLife (MET, Financial). The company underperformed the broad market, as low rates have pressured earnings. Shareholder returns also have suffered due to the company’s designation as a Structurally Important Financial Institution (SIFI), which limits management’s ability to return excess capital to shareholders. Resolution of either of these headwinds could unlock improved earnings-per-share growth and return on invested capital and support a valuation re-rating for the company. If neither of these headwinds are resolved, we see very little risk to the status quo, as shares are currently valued at less than 10 times next year’s earnings.”

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Dodge & Cox, 2015 Equity Midyear Review:

“Charles Pohl: In the first half of 2015, most equity markets around the world appreciated in local currency terms. However, the strong U.S. dollar provided a headwind in terms of dollar returns. The U.S. dollar was particularly strong against the euro and fortunately, both the Global Stock Fund and International Stock Fund had partial hedges against this depreciation in the value of the euro, and that helped the returns for both of those funds. We also note that the level of interest rates is especially low in the United States and many of the developed countries relative to historical levels. And we’ve examined the sensitivity of the funds relative to their benchmarks to a rise in interest rates and we find that both funds would benefit relative to their benchmarks from an increase in interest rates. Particularly interesting along this line is that the U.S. Federal Reserve has made statements that this fall they may begin increasing short-term interest rates.

Diana Strandberg: That’s true. There seem to be three big-picture issues on investors’ minds. You mentioned very low level of interest rates and when they might normalize, affecting equity markets worldwide. As well, the Greek sovereign debt crisis and the Chinese economic picture and recent stock market gyrations. We do see higher valuations around the world but we are continuing to find attractive long-term opportunities at reasonable valuations using our same approach of thorough, bottom-up research with a long time horizon and a strict price discipline.”

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