While the consensus among economists and investment advisors might be that interest rates may not go much higher, the new calculus states that these higher rates may be around longer than first expected. If so, what is one to do in a rising interest rate environment? The third quarter is in the books and the S&P 500 is ahead by some 12%. That’s the good news. If you want to be conservative on equities, maybe this is a time to book your profits, as the S&P 500 on average returns roughly 9% a year, so you are already ahead of the curve. Getting out of equities entirely is generally not plausible, so it’s time to look at other markets as this new interest rate regime is being ushered in.
In the first part of this two-part article, we will look at the effect of rising rates on stocks and bonds in general. In the second part we will focus on other asset classes to consider as alternatives to stocks and bonds.
The current market brings in the basic tenant of financial management, in that one must weigh risk vs. return. As interest rates rise on less risky assets like treasury bonds and certificates of deposit, investors are more likely to eschew the higher risk of the stock market and allocate more of their portfolio to fixed income. Let’s take a look at the macro picture on stocks and bonds, and then look at alternative asset classes that may be appropriate now.
The Impact on Stocks
All else being equal, rising rates tend to weigh on stock valuations, as they can drag on corporate profits and growth potential. This effect often plays out in anticipation of Fed action. Still, different areas of the market may react differently. We can take a broad brush to the market and divide it into growth stocks, dividend paying stocks, and the financials for terms of analysis.
Growth stocks: When interest rates are trending higher, it can clip the wings of pricey growth stocks, whose valuations are predicated on future returns. Technology was on a tear in the first part of the year, with companies like Nvidia, Microsoft, and Alphabet all benefiting from the surge in the speculation of AI. When interest rates are low or soon expected to fall, traders are willing to pay higher multiples of a company’s near-term earnings to share in its far-off growth. When rates go up, it instantly raises the bar on far-out profits needed to justify today’s stock prices.
Dividend payers: With bonds now offering investors potentially higher coupon rates and less risk, dividend payers may need to increase their yield to compete. Higher interest rates can also pressure corporate profitability and, thus, make it harder to pay dividends, particularly for heavily indebted companies. Fewer than 30 stocks in the S&P 500 have a dividend yield above that on the six-month Treasury bill, according to FactSet. That’s much different from most of the past decade when interest rates were near zero and hundreds of stocks within the index offered higher yields. At the end of 2021, before rates began to rise, there were 379 index constituents that offered a better yield than the Treasury bill, according to Birinyi Associates. As mentioned, it comes back to risk vs. return. Investors aren’t likely to own these few dividend stocks when yields are rising on risk-free government bonds.
Financials: The financial sector is one area where higher interest rates may serve as a tailwind since lenders can potentially earn more on loans. Historically, banks and financial institutions have outperformed the S&P 500 during periods of rising rates.
The Impact on Bonds
The Fed sets the federal funds rate, which is the interest rate commercial banks charge each other to borrow money for a very short term, usually overnight. Typically, when the federal funds rate rises, it pushes interest rates for other bonds higher as well. And when interest rates rise, bond prices tend to fall. These recent rate hikes led to a very bad year in 2022 for the bond market, and not much better thus far in 2023. Investors know that bonds issued in the future will likely pay larger coupons than current bonds, which pushes yields higher. The rally in the U.S. dollar has also increased demand for dollar denominated bonds thus adding fuel to the fire.
Against a backdrop of persistent inflation, geopolitical turmoil and market volatility, one may feel lost regarding which way to turn as the Fed aggressively tightens monetary policy. We’ll take a look at some of the basic financial investment tenants, as well as strategies and alternatives to stocks and bonds in the second part of this series.
To help you navigate this complex landscape, we’ve compiled a list of investment strategies that you can use to profit from rising interest rates. From fixed income securities with short durations to dividend paying stocks and real estate investment trusts (REITs), there are a range of options to choose from, each with its risks and potential rewards. By considering these different strategies and evaluating how they fit into your overall investment plan, you can take advantage of rising interest rates and potentially boost your portfolio returns.
