How to Prepare Your Portfolio for Today’s Rising Rate Environment
For years, borrowers have enjoyed near-zero interest rates, but that’s about to change. In June, the Federal Reserve (the Fed) raised the federal interest rate by 75 basis points — the largest increase since 1994 — and communicated its intention to continue raising rates throughout 2022 and into 2023.
Interest rate increases, which are called “tightening cycles,” are intended to help cool the economy. Inflation has reached a 40-year high, driven in part by increases in housing and energy costs, as well as strong demand for goods and services paired with supply-chain shortages. As of May 2022, inflation had surged to 8.6% year over year, a more than fourfold increase over the Fed’s 2% long-term inflation target. Through a series of interest rate hikes, the Fed intends to reduce inflation until it falls in line with its objective.
First Republic
Investment Management
and Research Team
First Republic Private Wealth Management
Higher interest rates directly affect consumers, and the effects of rate hikes reverberate across the entire economy, impacting individuals and organizations alike. Here, we will discuss how a rising rate environment may impact fixed income and equity investments, as well as strategies investors may wish to consider to adjust their portfolios accordingly.
How a tightening cycle affects the economy
On a basic level, higher interest rates raise the cost of borrowing. For more than a decade, low interest rates have allowed individuals and organizations to borrow money relatively inexpensively, encouraging them to spend. However, as inflation continues to run hot, the Fed has raised — and may continue to raise — rates to rein in spending and moderate inflation.
Higher interest rates lead to higher mortgage costs, for example, which increases pressure on prospective homebuyers. A rising rate environment also puts a damper on discretionary spending, helping to slow down the demand that’s driving up prices. Finally, raising interest rates may also encourage saving, as consumers realize greater returns from the money in some of their savings accounts, retirement accounts and other deposit savings vehicles.
How rising rates impact fixed income investments
Higher interest rates also impact fixed income investments. For bonds, it’s all about the math: As interest rates go up, yields increase and the prices of existing bonds go down. This trend is particularly stark in bonds with a long time to maturity, and bonds with a longer duration decrease in price more than those with a shorter duration.
As a result, investors should consider the following:
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1.Shortening the duration in their fixed income portfolios, since shorter duration bonds tend to decrease in price less than longer-duration bonds.
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2.Bond laddering, or purchasing bonds of different durations within the same portfolio, to help manage risk.
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3.Investing in floating rate bonds, which have a variable interest rate to maximize yields as federal interest rates continue to increase.
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4.Exploring more active bond managers; this may help minimize risk by managing duration and security selection as the interest rates — and the economy — continue to change.
The more nuanced impact on equities
While the impact of rising rates on bonds is fairly straightforward, the impact on the stock market is more complex.
Historically, investors have enjoyed positive returns in 13 of the past 18 tightening cycles since 1954. In particular, equities tend to speed into the first rate increase and slow down thereafter. However, persistent tightening cycles can be deleterious for equities, particularly if they result in an economic recession.
Yet not all equities are affected equally. During tightening cycles, stocks with higher dividends and buybacks — such as utilities, energy and telecommunications — may offer near-term gains for investors. When growth is scarce, investors may pay a premium for stocks in segments of the market that consistently enjoy above-average earnings growth, such as information technology.
In terms of style, growth stocks — particularly small-cap growth — are historically among those hardest hit, and value has tended to outperform growth in both large- and small-cap stocks after rate hikes. Lastly, rising rates tend to strengthen the U.S. dollar (USD), which may weaken international equities, particularly those in developed international markets.
Overall, a mix of safety, yield and growth tends to perform best. Investors may consider additional actions:
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1.Targeting sectors that could potentially benefit from higher rates, such as energy and financials.
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2.Diversifying their income. Avoid too much concentration on high-dividend equities, as changes to dividend policy are common during times of economic uncertainty.
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3.Investing in currency. The USD is expected to continue to strengthen during the remainder of 2022.
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4.Seeking out real assets, including commodities or real estate. Commodities have historically been a good inflation hedge, and a curb in oil production paired with an increase in demand for several commodities makes this an attractive asset class.
The bottom line
While we have yet to fully realize how the Fed’s existing rate hikes — and further increases on the horizon — will impact the markets and the economy, we are in a period of higher volatility. By remaining vigilant and taking steps to adjust your investment strategy as needed, you can position your portfolio to weather the storm.
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