As central banks around the world set interest rates that strongly influence all sorts of debts, from mortgages to student loans to treasury bills to corporate bonds, here are 5 porfolio considerations to consider with rising rates.
When interest rates are low, it reduces the borrowing costs and encourages businesses to borrow and expand more, and allows consumers to leverage up more for spending. Basically, people and businesses can take on much more debt because their interest payments are so low.
But when rates go up like they are now in many places including the U.S., it increases borrowing costs, which has the opposite effect. It also encourages people to save more money.
Related: Income + Tariffs + Inflation = Underperformance
The U.S. Federal Reserve has a dual mandate: to maximize employment and keep inflation at a stable (approximately 2%) annual rate. Central banks around the world follow similar principles.
When interest rates are kept low for long, it helps strengthen the economy and increase employment in the short term, but can lead to inflation and asset bubbles. When interest rates are increased too quickly or too high, it can reduce inflation but can slow down the economy and reduce asset values across the board.
In fact, an increase in the Federal Reserve interest rate has preceded all U.S. recessions (gray) in modern history:
Source: Federal Reserve Bank of St. Louis (click for a bigger view)
The world has been in an unprecedented period of low interest rates across the developed world over the past decade, and now interest rates are beginning to rise again. This can have a dramatic effect on stock valuations and portfolio performance, and this recent volatile market correction was partially triggered by rising treasury yields.
Here’s the current expected trajectory of interest rates for 2018 and 2019:
Source: JP Morgan Guide to the Markets
The Federal Reserve began increasing rates three years ago at a very gradual pace. They expect to do three 0.25% rate hikes in 2018 and two more in 2019, and then who knows.
The market, however, is pricing in about two rate hikes in 2018.
Central Bank Balance Sheet Unwinding
In addition, the Federal Reserve began gradually reducing its balance sheet in late 2017 and is expected to continue to do so through 2021.
The balance sheet increased massively during and after the financial crisis due to Quantitative Easing, where they bought tons of treasuries, mortgage-backed securities, and other investments to increase liquidity in the markets:
Source: JP Morgan Guide to the Markets
Other central banks around the world did similar things, and expanded their balance sheets as well. For example, the Bank of Japan started buying ETFs in 2010 and hasn’t stopped since. They now hold three-quarters of Japan’s ETF market, and this continuous buying has helped prop up Japanese equities and reduce volatility.
But now the U.S. Federal Reserve is shrinking its balance sheet, and the European Central Bank and the Bank of Japan are initiating plans to reduce balance sheet expansion as well:
Source: JP Morgan Guide to the Markets
This will act as a headwind against stock valuations over the next few years, and so will rising rates. It does not mean for sure that stock valuations will decrease, but it’s a strong factor against them.
On the other hand, rates generally go up late in the business cycle, when unemployment is at its lowest point, the economy is firing on all cylinders, and corporate profits are high.
Impact on Stock Valuations
Generally speaking, interest rates and stock market valuations are inversely correlated.
The same inverse relationship is true for other valuation metrics, like market-capitalization-to-GDP, or price-to-book, or price-to-sales.
A significant reason for this is that it changes investor incentives.
When interest rates are extremely low, savings accounts and bonds give investors terribly low returns, and so they are incentivized to seek out risk and invest in equities and other assets that produce higher returns and higher dividend yields in exchange for higher volatility. This includes retirees that are trying to live off their investment income. All of this increased interest in equities pushes up stock valuations.
However, when interest rates are high, investors can get decent returns from lower-volatility bonds and savings accounts, so people are less incentivized to seek out risk. They can reduce their equity exposure, which means less demand for equities and therefore lower valuations.
Related: Strategic Versus Tactical Asset Allocation
After such a long period of low interest rates and a long economic expansion, U.S. investors have more invested in equities than they’ve ever had in the past 18 years. This has helped push up stock valuations to the second-highest they’ve ever been.
That opens up questions of what happens when interest rates keep rising, and what happens when central banks begin quantitative tightening instead of quantitative easing. This recent 10% market correction was partially triggered by small rate increases in U.S. treasuries, showing how intertwined our high stock valuations are with monetary policy.
I recommend that you do a back-of-the-envelope calculation on what would happen to your portfolio if stock valuations reverted closer to their historical average. Not necessarily equal to their historical average, but closer to it. And then make sure you are comfortable with that level of risk, or adjust accordingly.
Here’s an example:
About a week before this recent market correction, I wrote an article on FEDweek called “By This Metric, Stocks Have Never Been More Expensive” that discussed the S&P 500’s price-to-sales ratio.
In that article, I pointed out that the S&P 500 average price-to-sales ratio was 1.3 in 2013 and just five years later in early 2018 had climbed to 2.3, which is a 75% increase and higher than any market top in history. I wrote that if the price-to-sales ratio were to fall to 2 (still higher than any previous market top), it would mean a 14% market decline. If it were to fall to where it was just a few years ago to 1.5, it would be a massive 35% market decline.
The fact that we just had a 10% market decline shouldn’t be surprising, given how highly-valued markets had become. The recent surge in the S&P 500 over the last couple years was driven far more by expansion of valuations than it was by fundamental earnings growth.
No valuation metric is perfect, and you can do this to a number of valuation metrics like average price-to-earnings, dividend yield, or price-to-book, to get an idea of how highly-valued we still are by historical standards and what even partial mean reversion would do to the S&P 500.
5 Portfolio Moves For Rising Rates
When we’re 9 years into the second longest and second biggest bull market in U.S. history, valuations are high, and interest rates are rising, risk is high across the board.
But there are moves to take that can buffer you against big market declines.
1) Check Your Diversification
Broadly speaking, the first thing to do is to check your diversification and allocation to ensure that your portfolio risk profile properly matches your age and financial goals.
Retail investors typically jump into equities after stocks have already gone up high, and then sell after stocks fall.
But smarter investors should do one of two things instead:
- Buy and hold. Keep the same allocation regardless of what’s happening.
- Reduce risk exposure when valuations are high late into a market cycle.
By holding your ground and keeping the same allocation with regular re-balancing, you should do very well over the long term. You’ll naturally sell high and buy low, without market timing.
Like this:
On the other hand, by reducing your equity exposure when stocks are highly-valued, and increasing your equity exposure after large declines, you may be able to outperform and reduce volatility, but it’s harder to do.
Whatever you do, don’t chase performance. Don’t start to overweight equities after they’ve already gone up a lot. Stay focused on long-term growth and proper diversification.
2) Take a Look at Your Bonds
Long-term bonds are more sensitive to interest rate risk than short-term bonds.
A rising rate environment gives investors better bond yields, but the prices of existing bonds decline because their yields need to align with yields issued by new bonds.
Here’s a simplified discounted cash flow equation for bond pricing, showing that when the expected rate of return (i) goes up to complete with newly-issued higher-yielding bonds, the current bond price must decrease:
If you have a diversified bond fund that includes bonds of various maturities, you probably don’t need to worry about this too much. But if you want to tweak it a bit, shorter-term bonds and cash can hold up better in rising rate environments than longer-term bonds.
3) Invest Abroad, Especially in Emerging Markets
In addition to the United States, interest rates are rising in Canada, Mexico, and several other countries. And they’re holding roughly flat for the time being in most of Europe and Japan (but their central banks are tapering off their support).
But in many emerging markets, interest rates are declining. Not all global economies are synchronized, and this can give investors opportunity.
I’m a strong advocate for investors having emerging markets exposure over the next ten years, and I weight them significantly in my personal portfolio.
Any individual year might be bad, because that’s the nature of markets, but I’ll be surprised if emerging markets as a whole don’t outperform U.S. equities over the next decade.
Here is the valuation comparison between the total U.S. stock market, developed international markets, and emerging markets:
Source: Vanguard
Emerging markets are trading at lower price-to-book multiples and lower price-to-earnings multiples than their developed counterparts, but have faster earnings growth.
From 2002-2007, emerging markets had a massive valuation increase, resulting in extremely highly-valued stocks. As a result, even though they continued to grow over the past decade, their stock returns have been largely flat as valuations declined, which offset that growth.
But going forward, their valuations are now down to reasonable levels and their future returns are expected to be better. Their economies are growing more quickly than developed markets while starting now from a point of reasonable valuations.
4) Buy Companies that Benefit from Rising Rates
While interest rates are inversely proportional with stock valuations in general, it doesn’t mean there aren’t individual companies that earn bigger profits when interest rate spreads are higher.
Banks are the most commonly-used example. They make money by borrowing at a very low rate (typically via savings accounts), and lending at higher rates (like mortgages). When interest rates are very low, the spread between these rates is small, but when rates are higher, they can earn bigger profits from a bigger spread.
As the Federal Reserve began increasing interest rates, average bank net interest margins quickly followed.
Quickly rising interest rates can be problematic for banks, but in general higher interest rates by the Federal Reserve allows banks to operate at a higher net interest margin, which means better profitability.
Insurance stocks benefit even more directly from higher interest rates.
The way insurance companies work is that they collect a lot of insurance premiums, pay out a lot of customer claims, and all the while they keep a “float” that they can invest conservatively and keep the profits. They don’t make much money from the actual insurance business; they make the bulk of their money from the investment income that they can generate on their float.
Insurance companies primarily invest in bonds. They usually hold their bonds to maturity, so they don’t care about changes in bond prices; they only care about yield and safety. In low interest rate environments, top-quality bonds pay very low rates and barely keep up with inflation. But in high interest rate environments, good bonds pay out higher yields.
For that reason, insurance companies become more profitable when they can invest in investment-grade bonds that pay decent yields. In other words, when interest rates are higher.
I cover bank stocks frequently in my free newsletter, and show what investments I’m personally holding.
5) Shop for Bargains in Rate-Sensitive Investments
On the other end of the spectrum, sometimes the market overreacts to investments that are considered sensitive to interest rates, which allows for contrarian investors to go bargain-hunting.
Very asset-heavy businesses need to use a lot of leverage to earn decent returns on equity, but they can safely support that level of leverage due to the high reliability of their cash flows. But because they use so much debt financing, when rates go up their costs of borrowing go up quite a bit as well. Plus, as rates go up investors demand higher yields from dividend-paying equities, meaning their stock prices decline.
This makes the market perceive them as sensitive to changing interest rates.
Real Estate Investment Trusts (REITs) for example, are commonly thought of as moving sharply inversely to interest rates. They use leverage for real estate and pay high yields. When rates go up, REITs go down, right?
Well, not exactly. As articles like the one in that link show, interest rates don’t have a significant impact on REIT performance over the long term, even if it increases their volatility in the short term. Especially if you buy high-quality REITs that use mostly fixed-rate financing and maintain stronger than average balance sheets.
As of this writing, REITs are already down nearly 20% from their 2016 high.
When you’re worried about the potential for high valuations and market crashes, look at areas where markets have already crashed and now have reasonable valuations.
According to most valuation metrics, REITs are a better buy right now than the S&P 500 if your holding period is long enough to let fundamental investing work its magic.
The largest REIT fund, Vanguard’s Real Estate ETF VNQ, offers a diversified low-cost high-yielding investment, or you can hand-pick your REITs for potentially better performance.
A lot of investors are worried about the “Amazon Effect” on REITs, because real estate is becoming less important as online commerce keeps taking market share. I used to shop at Target for supplies and go to malls for clothes and shoes, but now I get most of my supplies from Amazon and a lot of my clothes and shoes from Zappos (owned by Amazon).
However, the index that VNQ follows now only has 15% exposure to retail REITs, and a significant percentage of this chunk consists of things like restaurants, gyms, convenience stores, club warehouses, and other Amazon-resistant things.
The other 85% consists of properties like cell towers, residential apartments, offices, data centers, retirement homes, hospitals, hotels, and industrial properties, including logistics properties that benefit from online commerce.
I maintain a mostly rate-agnostic portfolio, meaning I specifically balance asset-heavy equities (like infrastructure and real estate) with financials (like banks and insurers), which complement each other well.
Final Words
Investing over the past 9 years has been easy, because just about everything has gone up.
Going forward, it’ll get more challenging again. We’re later in the business market cycle, valuations are high, and interest rates are rising.
The way I’m approaching this is continuing to be diversified, and investing more heavily in areas that are cheaply-priced relative to their historical norms and fundamentals.
I currently like emerging markets, quality financial stocks, energy/commodities, and REITs at current prices, but also remain broadly diversified into various asset classes.
This article has been republished with permission from Lyn Alden.