Between European instability, increasing market volatility and a resurgence of active management, a number of interconnected trends are currently playing out. But all investment decisions start with interest rates. And, thus, any change to rates is something investors should take heed of.

A Brief History

In response to the 2008 financial crisis, the Federal Reserve lowered interest rates to previously unseen levels: between 0.0% and 0.25% and kept them there until the end of 2015. The move had a resounding impact on asset prices as investors scrambled to riskier assets to find returns.

Since 2008, the S&P 500 has enjoyed the second longest bull market in history, posting an average annual total return of over 15%. However, the Federal Reserve’s recent actions put the future of that run in question.

Beginning in 2015, the Fed began raising rates. It has done so six times since, most recently in March, and has indicated that it will again twice more before the end of the year. Up to now, the market has readily absorbed these increases, mainly because they’ve been small and well-telegraphed. This may change as rates rise higher.

The key rate that investors look to is the 10-year U.S. Treasury. The current yield on the 10-year is around 2.8%, though it spiked over 3.1% earlier this month. Assuming that we see two more rate increases this year, the 10-year rate is likely to increase to around 4.0%.

Historically, the 10-year has returned around 5%. If yields return to those levels, bonds will be much more attractive investments than they have been of late. As a result, investors may choose to return to bonds, increasing increasing outflows from stocks subduing stock market returns.

Broader Implications

Rising interest rates may also affect consumer borrowing. Historically low interest rates have allowed for historically low mortgage rates, which supports the housing market. With mortgage rates lower, the housing market is currently experiencing a shortage of inventory, especially for first-time buyers. High demand and limited supply have driven prices higher but wage growth has lagged, pushing some markets into overvalued territory.

Continued high prices, combined with higher mortgage rates could result in a deceleration in home price increases, which could affect the U.S. economic growth, as the housing market is a key driver of the U.S. economy. Further, Housing purchases are often followed by a series of other purchases to outfit the home so any slowdown in housing sales could result in fewer consumer purchases, which in turn translates into slower economic growth. Consumer purchases account for approximately 70% of U.S. economic growth.

Malaise in the Developed World

While interest rates have risen at home, the political situation in Europe has begun to sour. Following rising unrest in the European Union, punctuated by Brexit, the status quo was dealt another blow by the recent Italian national elections.

The March elections produced no clear winner but led to rise of two antiestablishment, eurosceptic parties who captured around half of the vote. Although neither party campaigned on withdrawing from the EU, there are worries that the new government may pass legislation that serves as a de facto withdrawal. While such legislation has yet to materialize, the third-largest economy in the Eurozone is likely to destabilize markets for the foreseeable future.

Italy isn’t the only European country shaken by unrest. In Hungary and Poland, ruling parties have been actively adopting policies counter to European Union mandates, even though they receive millions in EU subsidies. Hungary, once a model of democracy in post-Soviet Europe, now resembles an autocracy. Poland recently elected a far-right government that has stacked its previously independent judiciary with political appointees. As   far-right political parties continue to rise throughout Europe, the European Union’s viability in its current form may become an open question.  

The Effects of a Volatile Market

Geopolitical turbulence, rising rates and other events have led to increased market volatility year-to-date. That’s not to say that the current market environment is abnormal. The ten-year bull market following the Great Recession was marked by steady growth and low volatility. That said, the return of normal levels of volatility poses a challenge to investors who have grown used to the unusual calm of the preceding years. For example, over the past decade, investors have been rewarded for buying market dips but ensuing corrections may not present such obvious opportunities.

One trend that may have played itself out is the role that Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX) and Alphabet (GOOGL) , also known as FAANG​ stocks​​​​​​, have played in pushing the market higher. In 2017, the group accounted for 4.3% of the S&P 500’s 21% return. However, despite continued strong performance from the stocks in the group, valuations are high to severely stretched and the group may have trouble continuing to push markets higher going forward.

The past few years have seen ever increasing sums moving into passive strategies, with $692 billion of inflows in 2017 alone. These strategies have performed very well in the recent bull market, but may offer a more uncertain outcome in a volatile market. Although active strategies do not always outperform passive, investors may be tempted to increase their chances of outperformance with an active strategy rather than settling for market returns, especially when those market returns may not be as dependable as they’ve been in the past.

This means that active management strategies may be increasingly embraced by investors who seek to outperform as well as to protect themselves from future potential downside.

The current market environment is marked by increasing uncertainty. A number of trends that have played out for many years look to be coming to an end and it’s not clear what will take their place. One thing that does seem certain is that volatility will continue to be an issue. Increasing political uncertainty will make investors nervous and jittery. And rising interest rates will spur investors to adopt changes as investment strategies that have worked well in the recent past will need to be modified. Passive buy and hold approaches will likely lose their appeal. And new market leaders will likely come to the fore. All of which means the second half of the year will be an interesting and pivotal one.