Interest rates are on the rise. Is that a good thing or bad thing for you as an investor? The answer, as with most things in life is, “it depends.”
Interest rates have done an incredible turnaround in the past five months, increasing a full 1.0% from July’s all-time low. Much of that rise was powered by the November election results with investors acting on their hope that winner Donald Trump’s proposed economic policies will bring both economic growth and inflation.
But rising interest rates could usher in a bear market for bonds. Why? Because when rates rise for an extended period bond prices decrease, as the two have an inverse relationship. Long-term bonds, those with 10-30 year maturities are more heavily impacted by interest rate changes than short-term bonds with 1-3 year maturities.
Big rate gyrations, in both the short and long-term, can throw your investment portfolio out of balance, leaving you more vulnerable to loss and less able to take advantage of the market’s upward movement. So, what moves should you make now that interest rates are moving upwards? Here are some thoughts…
What’s the secret to investing in the current climate?
It seems likely that rates will continue to float higher in the coming months as optimism swells over Trump and his pro-growth policies. That upward trend is further fueled now that the Federal Reserve has increased its benchmark Fed Funds rate.
Interest rates may very well level off as investors realize there’s not a structural inflation problem yet, as our GDP and wage growth remains too low to force up prices. We may see similar sluggish rate growth in the long term as economic growth is limited by anemic population growth and the lingering debt burden that keeps many people from purchasing big-ticket items.
Higher interest rates eventually become a bad thing for the economy. The exact level is hard to predict, but many economists start to worry when rates get to the 3.0%-3.5% range. Any higher and inflationary pressures drag down corporate profits enough to trigger a recession and, yes, send interest rates lower.
In a period of rising interest rates, bonds will suffer. Case in point: November was the worst month for bonds in 12 years! But keep that in perspective. The aggregate bond index fell 2.4%. Compare that to stocks, which are much more volatile. The S&P’s worst monthly performance in 12 years was a 16.9% drop in October 2008. You should own bonds not only for consistent income but to offset that sort of volatility in your portfolio.
Stocks, on the contrary, generally benefit from rising rates as they suggest stronger economic growth. Of course, not all sectors will see an upside. Cyclical industries such as financial institutions, industrial companies and energy providers will do better, while shares in the RUST sector companies — REITs, utilities, consumer staples, telecommunication — will likely dip.
So, what’s the secret to investing in the current climate? Continue to build a diversified portfolio made up of quality stocks and bonds that will pay you income through the ups and downs of the markets and the world. Not very exciting, and not much of a secret, but it’s the best strategy to limit your downside and maximize your potential upside, regardless of where rates are headed or who occupies the White House.