Interest rates may be rising soon, and investors should be anticipating what that could mean for their stock and bond holdings.
Depending on their portfolios, investors may see certain sectors weakened and other sectors strengthened by rising interest rates. It may have them reevaluating their bond holdings and the strength of the stock market.
Wondering what this means for your stock and bond holdings? Take a deeper dive into what a potential rise in interest rates could do to your investments:
— Why could interest rates rise?
— Interest rates and equity valuations.
— Understand how rising interest rates relate to corporate earnings.
— How to treat stocks when interest rates rise.
— How to treat bonds when interest rates rise.
Why Could Interest Rates Rise?
Right now, the Federal Reserve continues to buy $80 billion worth of Treasury securities along with $40 billion of mortgage-backed securities each month to keep long-term interest rates lower.
This round of quantitative easing arose as a result of the coronavirus pandemic to stimulate the economy. But as the economy makes progress, Americans could expect a reduction in asset purchases and a potential rise in interest rates.
“As investors gain confidence in the sustainability of this expansion, and the Fed, at the same time, starts dialing back its accommodation, the path of least resistance for long-term interest rates will be higher,” says Angelo Kourkafas, investment strategist at Edward Jones in St. Louis.
Other experts agree with this prediction. “Rates are likely to move higher, not lower, toward the second half of this year over the next several months or so,” says George Mateyo, chief investment officer of Key Private Bank in Cleveland.
In fact, the next step toward rising rates is already on the horizon. The countdown to tapering has started, Kourkafas says.
Tapering refers to the gradual easing of the Fed’s buying of asset purchases, including Treasury securities and mortgage-backed securities, to slow monetary stimulus. So what does this mean for the stock market and, most important, your investment portfolio?
“It doesn’t necessarily mean that stocks will go down, but it does mean that they may have volatility in the later half of this year,” Mateyo says.
Interest Rates and Equity Valuations
The Fed’s lending practices have supported the economy in its road to recovery, and the economy has rebounded from the early, dark days of the coronavirus pandemic. But as a result of the pandemic, American industry has faced a combination of labor shortages, supply chain constraints and higher consumer demand. These, along with stimulative federal spending packages, have led to rising inflation concerns for investors, with the added complication of potential deceleration of economic growth.
“A real risk investors might be missing right now is the risk of stagflation, or the persistent increase in price pressures alongside slowing economic growth,” says Danielle DiMartino Booth, CEO and chief strategist of Quill Intelligence, based in Dallas. For the average U.S. household’s budget, DIMartino Booth adds, the most important element is the cost of housing, which is rising at a historic pace.
The risk of stagflation puts into question whether the current economic growth rate can keep up with high equity prices. During this period of lower interest rates, equity markets have been performing well: The S&P 500 is up more than 30% year over year and has gained about 100% since the pandemic-induced crash in March 2020. But this is leading some investors to question whether they’re overvalued.
Understand How Rising Interest Rates Relate to Corporate Earnings
The direction of interest rates can impact overall market activity and the movements of stock prices. When interest rates are low, companies and consumers can borrower cheaply and tend to spend more money, which can boost corporate profits. When interest rates rise, consumers and companies typically curb their spending, which can result in lower stock prices.
In the current low interest rate environment, many companies are reporting impressive earnings, and it may be difficult for some to determine whether certain equities can continue to grow at a pace that justifies their price-to-earnings multiples.
One reason for high equity valuations is simply that corporate earnings are also high. Another big factor is that because the Fed has been keeping interest rates low, stocks have been the preferable asset class over bonds because they’ve been providing better yield.
Mateyo says public profits have been strong, citing a second-quarter earnings season in which 90% of S&P 500 companies that have reported exceeded expectations, a record proportion of companies beating estimates.
“You have lower interest rates that are supporting valuations, but you’ve also seen really strong earnings growth that supports this,” Mateyo says.
While companies have exhibited profitability and the market continues to rally, some growth stocks appear overvalued. That leads some to believe that stock prices may be separated from fundamentals.
“I think it’s very difficult to justify valuations in this particular environment,” DiMartino Booth says.
Some investors find it difficult to uphold current equity valuations. The only way they fill that gap, DiMartino Booth says, is with central bank liquidity: The $120 billion per month that the Federal Reserve continues to buy.
Investors who have been enjoying stock market gains but are concerned about the potential of rising rates in the future could prepare by reexamining how their investments are positioned in their portfolio.
The S&P 500 is market-capitalization-weighted, which means the largest companies — in 2021, this is a list dominated by tech giants including Apple Inc. (ticker: AAPL), Microsoft Corp. ( MSFT) and Amazon.com Inc. ( AMZN) — wield outsize influence on the direction of the index. Mateyo says that to revisit your index exposure, take a look at the composition of the index and adjust to a broader, equal-weighted index representation if necessary.
“When you invest that in a broader, equal-weighting index, you have more exposure to the broader parts of the economy, a little bit more exposure to mid-size companies as opposed to megasize companies and have a portion of companies that could benefit from the reopening of the economy, and also perhaps from interest rates going up again,” he says.
How to Treat Stocks When Interest Rates Rise
Rising interest rates may spur stock market volatility and hobble some sectors while boosting others.
Financial stocks and consumer discretionary stocks have the ability to perform well when interest rates rise, but this doesn’t mean investors should eliminate growth names. As the economy continues to grow, there are going to be different sectors that support this expansion of global GDP, with some contributing more than others during different economic cycles.
Many investors associate rising rates with stocks falling, but that is not the case, Kourkafas says. In reality, stocks have performed better during periods when rates are rising than when they are falling, he says. What can become a problem is if rates rise at a rapid pace.
The market should pay attention to the impact rising interest rates could have on high-growth technology stocks, Kourkafas says. Some companies in this category, such as Uber Technologies Inc. ( UBER) and Pinterest ( PINS), have had trouble reaching and maintaining profitability and derive a lot of their value from continued expansion and the promise of future cash flows.
“When interest rates rise, that means the rate at which the future cash flows are discounted is higher, making them worth less.”
Unprofitable, high-growth companies could experience some weakness if there is a meaningful rise in interest rates.
How to Treat Bonds When Interest Rates Rise
Bonds and interest rates have an inverse relationship, meaning that bond prices fall when interest rates rise.
But don’t liquidate your bond positions yet. Experts say bonds still hold value in an investment portfolio.
Kourkafas points out that bonds provide a steady stream of income and act as a portfolio stabilizer during times of volatility. While their value falls, the pace and length of rate increases plays an important role in performance.
“If rates rise slowly over time, earnings from the interest income that bond holders receive can offset the negative price returns,” he says.
In a rising rate environment, Kourkafas recommends bond laddering, or building a balanced fixed-income portfolio that includes short-, intermediate- and long-term bond maturities. “That can help the portfolio prepare for different scenarios depending on the path that interest rates take,” he says.
As the economic cycle continues to change, experts recommend allocating a combination of investment-grade and high-yield corporate bonds.
But investors don’t necessarily need to overhaul their portfolio based on what interest rates could do because interest rates can be difficult to predict.
“Having a balanced approach that includes owning sectors and stocks that are different from each other, diversifying, including large companies, small domestic companies, plus international, that can help investors not having to guess what interest rates are going to do,” Kourkafas says.
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