In this short series, the Investment Committee at Oakworth Capital Bank explored what might happen if, and when, interest rates rise. The first section focused on the bond market. The second analyzed what it could mean for equities. The third examined what investors should do with their asset allocation, and the final segment discussed how higher interest rates might impact the general economy, including consumer spending and private fixed investment.
In this final installment, members of the committee pulled pertinent highlights and quotes from each section to help tie things together. After all, it has been a very long time since we have seen a structural rising interest rate environment, and repetition can be an effective way to imparting meaningful information.
The Impact on Bonds (John Norris)
- Their value moves inversely with the direction of interest rates. This means when interest rates go up, bonds prices go down, and vice versa.
- The US Treasury market essentially sets the long-term price of money in the United States. After all, that is all interest rates are: the price of money.
- While we aren’t supposed to make guarantees or promises in the investment industry, I will promise you this: IF you purchase a 10-year bond which has a yield to maturity of 2%, and inflation averages 3% over the next decade, the purchasing power of your total cash flows will decline. In other words, you will lose money in relative terms, and why would you do that for an extended period of time when there are numerous alternative investments and mountains of stuff to buy?
- The Investment Committee has had a hard time finding value in the bond market, in general. There is simply too much interest rate risk and too little return potential. The question isn’t IF interest rates will head in the opposite direction at some point, the question is when.
- So, what to do? First, and most importantly, stay short. By this, I mean stick to securities with a short time until maturity during a rising interest rate environment. They will lose less of their value than those with longer maturities. There is a lot of math involved here, discounting the present value of future cash flows and all that jazz, so just trust me. Second, as always, do your credit work to determine how a particular bond will perform as rates rise. Third, ladder bond maturities in order to have a systematic way to capture rates as they go higher. Finally, if you just have to have some fixed income as rates are rising, corporate bonds will probably be the most attractive of all unattractive bond sectors.
The Impact on Equities (David McGrath)
- What are the effects of rising interest rates on equity markets? It sounds like such a simple question. When looked at in isolation, most would conclude that rising rates would hold back stock prices. Just consider a few of the effects of rising interest rates on stock valuations:
- Borrowing cost for companies will increase, and that should lower corporate earnings.
- Higher interest rates will mean that future earnings will be worth less in today’s dollars. This is the main reason that the price-to-earnings multiple for stocks will traditionally be lower as interest rates move up.
- Higher interest rates should slow loan demand, leading to a slower growing economy.
- Higher bond yields would make bonds a more compelling investment vs. stocks
- As consumer loan rates (mortgages) increase, the consumer should have less disposable income.
- Just a quick glance over this list would seem to support the prevailing thought that higher interest rates, in isolation, are a drag on stock valuation. The key word is all of this is isolation, and interest rates rarely move in isolation.
- When investors have confidence that the economic strength will continue, they will sell some of their bond holdings to try and produce a greater return with stocks. This will also push interest rates higher.
- Because almost every time, interest rates go down when the economy is weak, and interest rates go up when the economy is strong. I will take a strong economy every time!
- As we recover from this global pandemic, the stock market can handle rising interest rates, as long as it is accompanied with an economy that continues to get stronger. That is the “secret sauce” for strong equity returns.
The Impact on Asset Allocation (Sam Clement)
- With higher interest rates, a dollar ten years from now is worth a lot less than a dollar now. This is where quality comes in to play. If a dollar is worth much more now than in the future, we are going to place a higher value on those companies in which produce quality cash flow now.
- If rates are going to continue to rise and help provide tailwinds for domestic stocks, we will continue to remain overweight, and underweight international.
- What gold really likes is lower real yields. As rates start to rise, real yields should increase creating major headwinds for the asset.
- Higher rates mean lower bond prices and who wants that? If rates are going to rise, most of the fixed income universe will suffer.
- See the chart below for some basic asset allocation moves.
|Fixed Income||Underweight||Long-term Fixed Income|
|Neutral||Short-term Fixed Income|
The Impact on the Economy (Sam Harris)
- Due to a bit of an indirect arrangement, the Federal Reserve is able to tighten cash ‘in the system’ through increases in the Fed Fund Target Rate. This can be accomplished, by way of a balancing act, to slow both the economy or inflation if either runs too hot.
- A rate hike can create costly reverberations through the monetary system. It can deter folks from engaging in activities that may require financing – like buying a house with an expensive mortgage. It can also shift consumer purchase patterns, as well as consumer investment, which can lead to a decrease in aggregate demand.
- It’s not all ‘bad’, though. The Fed’s decision to increase rates can lead to currency appreciation – which is attributed to a more competitive marketplace as exports decrease in competitiveness and imports increase in competitiveness.
- A rising rate environment can also lead to the engagement of cost-cutting measures by businesses. As efficiency may increase with less overhead, those who were removed and replaced by alternatives, such as technology, may feel the brunt of the true ‘cost’.
- Remaining mindful of monetary policy should benefit anyone’s portfolio and, in turn, financial wellbeing. While none of these ‘outcomes’ from a rate hike by the Central Bank are guaranteed to occur, there will likely be some kind of market reaction to any increase. As such, it remains in best interest to mitigate the impact of rising rates through an appropriate asset allocation.
In closing, Wall Street analysts have been predicting higher interest rates for decades, and have been wrong. However, there is little room for rates to fall much further, in either absolute or relative terms, from their current levels. As such, our Investment Committee believes is it wise to be prepared if and when they eventually do go back up. This series on the potential impact of higher interest rates is just part of the education process for our clients, our friends, and ourselves to determine what the future might look like when analysts’ predictions finally come true.