For over a year the Federal Reserve has embarked on a massive interest rate hike aimed at taming record setting inflation in the wake of the Covid-19 pandemic and subsequent monetary and fiscal responses. For many people this is the first time that 7% mortgages and 5% savings account rates have existed, but it is important to remember that a country’s economy works in cycles and while each cycle will have its own unique factors and impacts, rising and falling interest rates always play a role at different times of the economic cycle. So yes, there was even a time when mortgage rates were well over 10% and savings accounts paid well over 5%!
Since interest rates play such an important role in both the macro and microeconomics, an informed investor ought to understand why. Whether it is watching a slumping 401K this summer or your mortgage broker quoting you a 7.8% rate for that house you’ve had your eye on – interest rates impact our lives.
When discussing financial markets and investing generally, interest rates are a critical factor that can affect various assets, including stocks, bonds, and real estate. Before delving into the intricate interplay between interest rates and stock or other risk assets, it’s essential to define some
- Interest Rates: The amount charged, expressed as a percentage of the principal, by a lender to a borrower for the use of assets. Typically that asset is cash.
- Risk Assets: Assets that have a significant degree of price volatility. Stocks are a primary example, but commodities, cryptocurrencies, and high-yield bonds also fall into this category.
- Bonds: Debt instruments that governments and corporations issue to raise capital. They pay periodic interest to bondholders and return the principal when they mature. Bonds can also be risk assets (as the Silicon Valley Bank implosion reminded us), however the US 3-month Treasury “T-Bill” is a type of short term bond that US investors will typically use as their “risk free” rate of return when comparing to other Risk Assets.
With these definitions in mind, let’s explore why and how sharply rising interest rates exert pressure on stock and other risk assets.
The Pressure of Rising Interest Rates on Risk Assets
- Discounted Cash Flows: One of the foundational methods to value a business or stock is by calculating its future cash flows and discounting them to their present value using a discount rate. The interest rate often influences this discount rate. When interest rates rise, the discount rate goes up, making future cash flows less valuable in today’s terms. This can result in a lower valuation for businesses and, by extension, their stock prices.
Example: Consider a company expected to generate $1 million in cash flow next year. If the discount rate is 5%, the present value of that cash flow is $952,380. But if the discount rate increases to 7%, the present value drops to $934,579. A seemingly small change in the discount rate caused a notable change in valuation.
- Cost of Borrowing: As interest rates increase, so does the cost of borrowing for companies. Firms that rely on debt for their operations or expansion will see their expenses go up, impacting their profitability and potentially their stock prices.
- Opportunity Cost: With higher interest rates, safer assets like government bonds start to offer better returns. This can make riskier assets, like stocks, less attractive by comparison, prompting investors to reallocate their portfolios.
- Consumer Spending: Higher interest rates often translate to more expensive loans and mortgages. As borrowing becomes more costly, consumers may reduce spending, which can negatively affect businesses and, subsequently, stock prices.
- For Short-Term Investors (less than 10 years):
- Diversify: A diversified portfolio can help insulate you from the worst effects of rising interest rates. Including a mix of assets like bonds, stocks, and perhaps real estate can be a prudent strategy.
- Stay Liquid: In a rising interest rate environment, having some liquidity (like cash) can be advantageous. It gives you the flexibility to invest when opportunities arise. Rising interest rates are a great opportunity for short term investors to continue to earn income without sacrificing liquidity.
- Re-evaluate Debt: If you have variable-rate loans, consider refinancing or paying them off. As interest rates climb, these loans will become more expensive.
- Focus on Quality: Investing in companies with solid fundamentals, low debt, and consistent cash flows can provide some protection against the adverse effects of rising interest rates. Companies that don’t have to rely too heavily on debt to finance their operations, can better weather interest rate hiking cycles.
For Long-Term Investors (over 10 years):
- Stay the Course: Historically, the stock market has delivered positive returns over long periods, despite fluctuating interest rates. If your investment horizon is long, short-term market disturbances might be mere blips in the grand scheme.
- Rebalance Periodically: As interest rates change, your portfolio’s allocation might shift. Regularly rebalancing ensures that your portfolio remains aligned with your long-term objectives. Rebalancing also has the added benefit of forcing you to buy low and sell high. An easy concept in theory, very hard to execute in practice without forced rebalancing.
- Consider Bond Ladders: This strategy involves buying a series of bonds with staggered maturity dates. This way, as each bond matures, you can reinvest the proceeds, potentially benefiting from the higher interest rates. For a more conservative and longer term investor this could be a great strategy.
- Look Globally: Diversifying your investments across global markets can provide added protection. Different regions might react differently to interest rate changes, offering opportunities for investors.
While rising interest rates can pose challenges, understanding their effects on the broader market can equip investors with the knowledge to navigate these changes. Whether you’re a short-term or long-term investor, staying informed, diversified, and proactive can help mitigate risks and potentially harness opportunities.