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Interest Rate Forecast For 2017: Predicting The Unpredictable

David Kotok, Interest rate forecast for 2017

With David Kotok, Chairman and Chief Investment Officer of Cumberland Advisors

Today we talk with David Kotok, Chairman and CIO of Cumberland Advisors, about the Federal Reserve fund rates, his interest rate forecast for 2017 and how he sees rates affecting and interacting with the stock market and the economy at large.  Steve begins the discussion by asking David to elaborate on the relationship between interest rates and stock prices.  His response is nuanced, but the core concept is that stocks (like other investments) need to be valued or benchmarked by comparison to the rate of return offered for risk-free 30-year US treasury bonds.  This risk-free rate is currently floating around 3%, so your stock portfolio is going to need to perform better than this over the same time period.  The basic tradeoff is that riskier assets should provide higher returns.  Investments can be valued by using the “discounting mechanism of a rate of interest” which approximates the potential upside from taking a riskier position like owning stocks.

Steve follows through on this insight by noting that when the risk-free rate goes up, stock prices should come down.  Why?  Because a higher risk-free rate means that stocks will need to perform even better than they do with a lower risk-free rate.  A lower stock price today means there is more room for appreciation and dividend payments going forward, which add up to higher returns.  The converse of this is true as well; that when rates decline, stock prices inch up because lower earnings or returns are required to beat the lower risk-free rate.

Interest Rate Forecast for 2017

As far as interest rates in 2017 are concerned, David believes the Federal Reserve will hike the Fed funds rate twice this year in 0.25% increments for a total of 0.5% or 50 basis points.   For those holding liquid assets like a money market fund, CD, or certain floating rate instruments, this means they should see a 0.5% increase in yield (interest paid) by the end of the year.  This cuts both ways, and borrowers who are paying interest tied to a benchmark rate like LIBOR (as many mortgages are), their interest payments will rise accordingly.  On balance, this is good news for lenders, and David is bullish on bank stocks for this reason.  That said, David acknowledges that there are other complications that factor into the economy, the Federal Reserve’s actions, and the markets’ reactions, from monetary policy to inflation and interest rates of foreign currencies.

The discussion then shifts to bonds—in particular, the strong sell-off of tax-free bonds at the end of 2016 and what that portends.  The widespread sale of municipal and other tax-free bonds caused their interest rates to jump from 3% to 4%, a large move for such a short time span.  David asserts that this trend was “way overdone” and believes the resulting yields on highly rated tax-free bonds will prove too sweet of a bargain to resist for many investors.  This kind of return may become even more attractive if income tax rates are lowered by the Trump administration, which many are expecting.

Interest Rates, Federal Spending, and Lower Taxes: Possible Bottleneck

Steve finishes the interview by asking David whether he’s concerned that a Trump’s stated policies of lower taxes and higher spending will drastically increase the country’s deficit.   His response affirms those concerns, and he mentions that he’s particularly worried that the US government will have to pay higher interest rates to borrow money.  He sees the past decade of extremely low-interest rates on government bonds winding down.  Moreover, it will happen at exactly the wrong time—when the Treasury will need to sell more bonds to simultaneously support lower tax revenues and infrastructure spending.  David believes this increase in rates and borrowing could act as a brake on the economy.

David Kotok will be speaking on Outlook for Interest Rates and Stock Market on February 8th and How Will the New President Affect Your Portfolio on February 9th at the MoneyShow Orlando.  You may register for free here.

Steve Pomeranz will be speaking on February 10th: Myth Busting Your Way to Riches.

For more information on the MoneyShow Orlando and to register for free, click here.

Disclosure: The opinions expressed are those of the interviewee and not necessarily United Capital.  Interviewee is not a representative of United Capital. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions.  Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances.  The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.

Read The Entire Transcript Here

Steve Pomeranz: David Kotok is the Chairman and Chief Investment Officer of Cumberland Advisors.  He holds a degree in economics from the Wharton School as well as dual Master’s degrees from the University of Pennsylvania.  He’s a frequent contributor to Bloomberg Fox Business and other media outlets.  Now he’ll also be speaking at the Money Show Orlando on February 8th on the outlook for interest rates and stock market, and he’ll be participating in a panel with Steve Forbes and others.  Now the Money Show is held this year at the Omni Resort in Orlando from February 8th to the 11th.

I too will be speaking at the show, as well, on February 10th.  My topic will be called “Myth Busting Your Way to Riches” where, for example, I’ll discuss how a simple investment in the wonderful S&P 500 may actually turn into a disaster for most investors.  I’ll discuss these and other investing delusions that prevent you from becoming rich.  You can register for free to see and hear all the terrific speakers, including David Kotok, at OrlandoMoneyShow.com or find out more at our website StevePomeranz.com. It’s a long intro, David.  Thanks for being patient, but welcome to the show.

David Kotok: Well, thank you, Steve.  I look forward to seeing you at the Money Show.  Money Show’s always a great opportunity for a variety of folks, because it’s packed with so much good information, and it’s an honor for me to get invited to be part of it.

Steve Pomeranz: In your bio, you wrote that you served as Chairman of the New Jersey Casino Reinvestment Development Authority, and I was wondering if you ran into our new president at the time.

David Kotok: I actually had lots of activity with him.  The Trump Casinos were part of the casinos that the Reinvestment Authority had to deal with.  I had one meeting with him that lasted two hours.  There were two other folks in the room and we had discussions about the Trump Casino obligations that were due or going to be due at the time.

Steve Pomeranz: And how did those conversations go?

David Kotok: Well, the conversation at that meeting was fine.  He was a businessman in a discussion about an obligation that he had.  I was the Chairman of the Authority at the time.  We had a pleasant exchange, I recall it now because of what has happened in his political career.

I don’t have anything other than favorable responses.  People ask me “was he rough or did he evidence any belligerency” and the answer is no.  He was a gentleman in the conversation, as I remember it, for two hours.  We subsequently had applications from his organization.  We held hearings on them.  All in all, it was an operating issue for the Casino Authority just like the other casinos, and that’s how I remember it.

There are some private things within that that are sealed, and I won’t talk about those, but, in a relationship sense, I don’t have any negatives about Donald Trump and his casinos from that era.  If anything, I would say there’s a positive impression that I had and that was that Trump had very skilled professionals, engineers, lawyers, architects, designers, very talented people representing him.  They were professional in what they do.

Steve Pomeranz: So a good team surrounding him maybe portends well for the team that he’s building around him now.

David Kotok: Well, this we’ll find out in due time and very soon I suspect.

Steve Pomeranz: Very soon.  All right, so you’re going to be speaking on interest rates and the level of interest rates in the upcoming year or so and what it means to the stock market.  First of all, why is the level of interest rates so tied into stock prices?

David Kotok: Well, two elements strike me in answer to that question, Steve.  First of all, if you look at the entire universe of stocks, think of it as, say, almost 5,000 companies that are American companies.  Suppose you were to glom them all together and have just one ticker symbol called Stock Market.  You could either buy the stock market or not buy the stock market.  What would you be doing?  You would be engaging in a long-term financial activity which had estimates of a rate of return. I could use the same description and describe a very long-term bond and, in fact, stocks are a substitute for long-duration assets like bonds.  So, the most enduring principle of valuing stocks in the stock market is the discounting mechanism of a rate of interest.

What do we do?  We take the riskless rate because that’s what you would obtain if you bought treasury notes or treasury bonds, and you say “Okay, how much more am I going to get paid for taking on risk?” We know today you can buy a US Treasury Bond due in 30 years, get paid without question and get a 3% return on your money.  If you’re going to invest in something for 30 years and you want to do it in the stock market, then you want to say, “Okay, I need more than the three which is promised to me without any risk in order to obtain a higher return and for me to take that risk.” Therein lies the tradeoff.  I think interest rates as a basic scenario, as a threshold, are the most enduring valuation mechanism we have.  Now, it gets complicated when you get into how our interest rate is set.  Do we have a central bank?  Yes, the Federal Reserve.  What is monetary policy?  How is it impacted by other countries and other interest rates in other currencies?  What happens if we have some inflation?  Does that erode the value?  These are all the questions and, at the Money Show, we’ll talk about them.

Steve Pomeranz: So, it’s important to future stock prices as to what the actual return, the risk-free rate of return is.  So, the risk-free rate of return goes up, then probably stock prices will have to come down to some degree in order for the future return of the stocks (which have a certain kind of set average amount of earnings) to be higher.  As rates rise—not immediately— but as rates rise, stock prices may fall; as rates fall stock prices may rise.  What is your forecast for 2017 with regards to the risk-free rate?

David Kotok: Well, our current forecast would be for two quarter-point hikes by the Federal Reserve sometime this year.  When is not clear, but we would expect that to occur staggered during the year and that would put the risk-free rate 50 basis points, a half of one percent higher than it is today.  So, if you think of that in the way it would translate for some investor: If they’re earning a half of one percent now, they could anticipate at the end of the year—if they’re on some form of a liquid asset or money market or floating rate instrument, something with a very short maturity— that a year from now, their earnings would be a half a point higher as an interest rate than it is today.

Steve Pomeranz: So, if you have CDs, you can expect somewhere around a half percent more under this scenario in interest, let’s say a year from now, based upon that forecast.

David Kotok: I would say that’s probably so, and if you’re a borrower and your loan is tied to the 90-day London Interbank Offered Rate, LIBOR, and you’re paying one percent today for three month LIBOR money, you can think of this as paying one and a half a year from now.

Steve Pomeranz: So, it’s going to transfer money from borrowers to the lenders and that’s maybe why the banks are going up in value.

David Kotok: It is so, and one of our managed ETF positions in our portfolios favors the large banks because we think they are the beneficiaries of this change.

Steve Pomeranz: Now I know you do a lot in tax-free bonds as well and we saw this big sell off in tax-free bonds which raised the yields on new purchases.  Do you think that’s going to continue, weak bond prices higher municipal yields, or is that overdone?

David Kotok: Well, once we get beyond the short-term interest rate, now we get into a lot of other questions about expectations and how that influences bond prices.  We think, in the tax-free bond space, that the sell- off in the bond market since Trump was elected was way overdone.  We had tax-free bonds which were around a 3% yield and next thing you know, in a matter of weeks, they were trading at a 4% yield.

Steve Pomeranz: Crazy.

David Kotok: Crazy, and so today a sophisticated or alert bond buyer can obtain a very high-grade tax-free return of four percent on a long-term tax-free municipal bond, while the 30-year treasury, for example, is at three.  I’m rounding the numbers a little.  So, you say to yourself “What rational argument could you make to make a four percent tax-free make sense when the taxable riskless is at three?”

Steve Pomeranz: Well, I think the answer would be that taxes are going to be coming down, tax rates, so that extra yield is not really going be as attractive as it would have been with higher tax rates, though you’re getting four net versus three pretax on risk-free. So no matter what, I guess you’re saying, it’s better either way.

David Kotok: Well, our view is this, the income tax code in the United States may be changed; it looks like it will.  The top brackets will go down if those changes occur.  The politics suggest that.  But the income tax of the United States is not going to be repealed.  We’re not going to go to no tax.

Steve Pomeranz: That’s disappointing, I was expecting …

David Kotok: Well, I’m, you know, some people at the Money Show may not like that, but the fact is that’s going to happen.  So, if the top bracket, Steve, is 33 or 30, a tax-free bond at four is still a very attractive investment when the riskless taxable is three percent. So, it’s a bargain.

Steve Pomeranz: Yeah, if you’re in any tax bracket at all, a decent tax bracket like you were mentioning the 28 or 30 or 33% bracket, and your bonds really need to be in tax-free bonds. I think that’s absolutely true.

Unfortunately, we’re short of time, so I just have a quick question for you.  Do you think that Trump’s stimulus package, which includes a reduction in taxes, is going to increase the deficit?  Because I know you’re worried about the level of deficit.

David Kotok: We have a baseline forecast which …and the answer to your question is yes…we see the deficit as widening, and we also see the interest rate that the federal government has to pay to borrow as rising.  We’ve had a benign period of a decade in which the United States of America has borrowed an additional $10 trillion, but interest rates went down and stayed down and, therefore, the interest bill to the budget was flat.  This is a wonderful period behind us.  It’s coming to an end, and so we see the interest bill in the budget rising, and we see the government borrowing more.  Those are two headwinds for financial markets.

Steve Pomeranz: My guest, David Kotok, Chairman and Chief Investment Officer of Cumberland Advisors.  He’ll be speaking at the Money Show in Orlando on February 8th at the Omni Resort Hotel.  Thank you for joining me, David, appreciate it.

David Kotok: Thank you.