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Interest rates are rising. How should investors respond?

David Lundgren, CFA®
July 28, 2022

Recent headlines, high inflation and an uptick in market volatility have understandably heightened concerns among many investors. David Lundgren, Chief Investment Officer of Hancock Whitney Asset Management, discusses recent market developments and shares his perspectives on portfolio considerations.

 

Interest rates are rising. How should investors respond?

 

Will interest rates continue to rise?

In 2020 as the pandemic was beginning, the Federal Reserve (Fed) took extraordinary measures to prevent economies from slipping further and/or deeper into recession. As a result, overnight interest rates dropped to near zero while longer term rates also declined to at or near all-time lows. Fast forward a couple years as pandemic restrictions eased and the U.S. has started to ‘return to normal’, so too has the Fed.

On July 27, Fed Chairman Jerome Powell announced a 0.75% increase in the Federal Funds rate. This follows a 0.75% move in June and the cumulative two month 1.5% hike was the steepest jump since the 1980s when inflation was also running at very high levels. The Fed will likely continue to raise rates for the remaining meetings in 2022 with the hope of reining in the highest inflation rates in decades. The size of rate increases going forward will be dependent on trends in inflation and the pace of economic activity with particular emphasis on employment data. Interest rates tied closely to overnight interest rates (such as money markets and savings accounts) generally move in tandem to rate hikes enacted by the Fed and therefore will likely continue to move higher assuming the Fed moves as expected.

While longer term yields definitely react to changes in Fed policy, other factors such as expected long-term growth and inflation also influence the movement of rates. In fact, the longer the maturity, the less influence Fed rate decisions may have on market yields. This became clear in early 2022, when it became apparent that more Fed rate hikes were coming and the yields of 2-year U.S. Treasuries jumped substantially from about 0.75% to over 3.0% in a very short period of time. Longer term rates also moved upward but not nearly at that same rate of change.

So to sum it up, yes, short-term interest rates are likely to move up for the rest of 2022. However, after reaching historically low levels for most of 2020-21, the U.S. Treasury 10 year note yield reached 3% in April 2022 and has mostly traded between 2.75% and 3.25% since then. We would expect longer term rates to remain around 3% for the remainder of the year.

 

What do rising rates mean for investors?

Much like the price of stocks, bond investment prices change over time. While these changes are usually smaller than experienced in the stock market, changes in bond prices do occur and move in the opposite direction of the change of interest rates. So if interest rates rise, then the price of bonds generally falls, and vice versa.

As an example, when interest rates dropped dramatically in 2020, bond prices increased and many bond investments produced total returns in the 5% plus range, which far exceeded the yield (or amount of income paid) on those bonds. The difference between yield and total return was the price of the bonds going up in value.

Conversely, when rates rise as they did in 2021 and so far in 2022, investors are greeted with negative returns for bond investments because price declines were greater than the income, or interest, generated from the bonds. While painful in the short term, rising rates can give long-term investors an opportunity to capture greater income return from bond investments over time.

Some investors, even after they understand bond investments more thoroughly, would prefer investments that don’t change in value. For that type of investor, there are many other solutions available such as bank or insurance products. Please consult a Hancock Whitney advisor for more information on these types of investments.

Higher rates also obviously lead to possible changes in car, home, and credit card interest rates, just to name a few. Make sure you are reviewing your interest rate terms and understand how rising rates may impact the amount of interest you are paying and whether there are lower cost options available.

 

Does the stock market also react to Fed policies?  

The answer is nuanced but generally yes.  As mentioned, the Fed is aggressively attempting to slow inflation. The tools the Fed often uses to do so are to raise interest rates, and to remove money from the financial system through something referred to as ‘open market operations’. Both these tools are used to slow demand and in turn economic growth.

Of the two tools, the effect rising interest rates have on the stock market is a bit easier to understand. If interest rates are higher, the more expensive it becomes to buy a house or car if financing is needed. It also can impact credit card interest rates. Spending more money on interest removes money from the pockets of consumers to do other things such as travel, dine out, and many other discretionary expenses. Reduced spending leads to a slower economy and potentially less earnings for companies. The same holds true for businesses. Higher rates may make it less likely that a company will build a new plant or invest in a new project as the interest expense associated with financing those types of activities increases. Additionally, interest expenses will be higher leading to lower profits (earnings) than they were able to achieve with lower rates.

Open market operations are more complex and can occur in several different ways. However, the end result of current policies underway is generally higher long term rates and less money in the financial system (the reverse occurred under the policies implemented during the pandemic). Both of the outcomes of these current policies tend to slow economic growth and potentially company earnings, which obviously may cause concern for stock investors. 

 

Should investors be worried about current geopolitical conflicts?

Unfortunately, as long as there have been humans, there has been conflict. The ongoing situation in Ukraine is horrific and troubling. It is only natural to watch what is unfolding and feel emotions. Sadness, fear, and anger probably top the list.

However, emotions and investing normally don’t mix well. So much so that there is even a measure followed by CNNMoney to gauge the stock market called the Fear and Greed Index. In theory, the index can be used to gauge whether the stock market is fairly priced by quantifying investor sentiment. It is based on the logic that excessive fear tends to drive down stock prices, and too much greed tends to have the opposite effect.

The Ukraine conflict will very likely continue to cause long term global economic implications as Russia will be isolated from most of the rest of the developed world for a long time to come. The biggest impact from this ‘global reshuffling’ will be felt in supply chains and continued pressure on the prices of food, energy and other commodities.

So what does this mean for your investment portfolio? The ability to predict what markets will do the next week, month or quarter is almost impossible and more volatility seems likely. And while predicting the short term is very difficult, we can use history as a guide to tell us that we will move beyond this conflict. Investors need to remember that a long-term approach will likely lead to favorable outcomes.

Asset allocation and diversification are key components of your investment portfolio that are particularly important during volatile and unpredictable markets. With the help of a trusted advisor, you can determine the asset mix appropriate for your investing horizon and risk tolerance. Keep a long-term perspective, don’t be unsettled by geopolitical conflict and ensure you have regular discussions with your investment advisor about your financial situation.

 

What moves should investors be making right now?

“Dow plunges 10% amid coronavirus fears for its worst day since the 1987 market crash” CNBC 3/11/2020

“Stock Market Slide Shows Inflation Worrywarts Were Right” Bloomberg 11/10/2021

“U.S. markets dive as Ukraine crisis keeps pushing up oil and gas prices” CBS News 3/7/2022

“Dow, Nasdaq suffer worst day since 2020 as stocks plunge” The Hill 5/5/2022

 

This is a very small sample of headlines highlighting the major issues faced by markets over the last few years. It is also the type of headline that causes worry and second guessing among many investors.

Throughout its history, the stock market has seen an incredible number of challenges. The tech bubble, 9/11, and the 2008-09 financial crisis are more recent examples. But there have also been world wars, runaway inflation, numerous political crises – the list goes on and on. Although these developments seem to be insurmountable in the moment, markets historically have recovered and moved forward. Of course, these outcomes are never guaranteed, but at the very least they serve as a guide to what markets have previously been able to achieve.

Trying to time the market around ‘events’ is a tricky game for even the most seasoned investment professionals. My recommendation in times like this is to understand your longer-term goals and objectives; work with an advisor to determine a long-term asset mix that could help achieve those goals; and stick to it. ‘Stick to it’ doesn’t necessarily mean ‘never change’. Over time, your financial situation evolves, as do your time horizon and personal risk tolerances. By working with a trusted professional, you’ll be able to ensure your portfolio and asset allocation reflect your current financial situation and will change with you.

 

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