Rising Interest Rates, Inflation, Volatility – Oh My!
Lions and tigers and bears – oh my. In the Wizard of Oz, Dorothy and her entourage faced perceived obstacle and fears as they linked arms and moved along their journey toward Oz. We too, face unanticipated financial and life challenges, our next steps mired in trepidation.
Right now, we have the inflation monster and nipping at our heals, interest rates breathing down our necks and market volatility bearing jagged teeth.
The Fed raised interest rates in May by 50 basis points, and I anticipate there will be more increases through the remainder of 2022. Fed Chair Jerome Powell recently stated “if we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings, we will do so.” Even though interest rates have been ticking up, they are still historically low.
What is the effect of rising interest rates on your investments?
Every asset class is impacted directly or indirectly when the Fed raises interest rates and it is important to understand as you consider your life situation, rebalance your portfolio or look at asset allocation and tax efficiencies.
Impact on Bonds
The price of bonds fall as interest rates rise. This is because newly issued bonds will pay higher coupon rates, while bonds that were issued at a lower interest rate offer lower coupon rates and will be worth less. Long-term bonds are especially exposed to interest rate risk because they lock up your money for a greater amount of time. While bonds may be an important part of your portfolio as they temper market volatility, the type of bonds and their maturities should be discerned. Bonds do have risk – interest rate risk. They can actually create volatility in your portfolio in a quickly rising interest rate environment.
Impact on Stocks
Unlike the direct effect of interest rates on bonds, the relationship with stocks is more complicated. It is more expensive for companies to borrow money to fund operations and is one component of growth. Because of higher borrowing costs, they may borrow less. Keep in mind we are still at historically low rates. Consumers may spend less if they are borrowing to make their purchases. This could also have a negative effect on public companies as they sell fewer products or services.
The Fed raises rates to temper inflation as the economy grows – which means higher stock prices. A complicated, delicate balancing act for the Feds. Bottom line, each company’s particular position and circumstances will be impacted differently by rising interest rates.
As a whole, higher interest rates haven’t dampened market returns. In the most recent five rate cycle hikes, Dow Jones Market Data analysis found that three leading stock market indexes only decline during one of those cycles.
What should you do with your investments?
There is no “one size fits all” solution. Understand that asset allocation and asset location is never one-and-done. Each person and portfolio are unique and you need to stay pro-active. Don’t fall into being reactive to market news and talking heads. Diversification is key, rebalancing is warranted and fine tuning for legislation, tax and interest rate environments is paramount.
Bonds have the role of a shock absorber in a well-diversified portfolio. Depending on your risk capacity and your risk tolerance, they will play a part. Right now it is important to diversity your fixed income portfolio. You may want to consider high-yield or emerging market bonds. High yield bonds are corporate bonds with lower credit quality, but they offer a higher payout due to the increased risk. Look at the term of your bond portfolio. Shorter term may be more prudent in our current environment.
Stocks should play a larger role. Stocks are the only way to overcome inflation. Again, you need to consider your capacity to take on risk as well as how you will stomach the roller coaster ride. Look at how companies align with your values and be discerning in which companies you own. Real assets such as real estate, commodities, precious metals and other “tangible” assets can play a part for additional diversification.
If you need additional income for cash flow and don’t want to depend on interest rate bound bonds, look to dividend producing, large company stocks. You may see a price pullback (a good time to buy them on sale), and these large companies are not likely to fail.
On your financial yellow brick road, make sure you are linked arm in arm with a team of professionals that will face the emotional fears and look at the uncertainties that lie around the corner with your ultimate quest or destination in mind.