Why has the Federal Reserve been raising interest rates?
When the Federal Reserve starts raising interest rates it usually means they’re trying to slow growth of the broader national economy. Each time they raise the interest rate it makes borrowing money more expensive for consumers, whether that’s a person or a firm or corporation. Why would the Federal Reserve ever want to slow down growth? At first blush, it seems counter-intuitive. The answer, in this case, is to combat inflation.
Year-Over-Year Inflation Rate
Over the last 12 months, as the US and global economies have been emerging from the disruptions caused by the pandemic and the response to it, there has been a steady uptick in inflation. Inflation is the economic response to there being more money in circulation than there are products, goods, or services to purchase. The Federal Reserve targets an inflation rate of 2% per year. Why 2%? Per the Federal Reserve, inflation of 2% over the longer run is most consistent with their mandate for maximum employment and price stability1.
In response to this pricing pressure, the Federal Reserve has started raising interest rates. As was widely anticipated, the Federal Reserve began its tightening policy by raising interest rates by 0.25% on March 16th and another 0.50% on May 4th. They have signaled that they anticipate more hikes over the year, with the next coming as early as their June meeting. The reason why these hikes are “anticipated” and not “scheduled” is because the Federal Reserve is carefully monitoring the domestic economy’s response to these interest rate hikes. They want to help cool down the economy, without overreacting and causing it to freeze up, pushing us into a recession.
How do interest rate hikes affect portfolios?
This year, the stock market has, generally, reacted negatively to the announcements from the Federal Reserve. Despite Chairman of the Federal Reserve, Jerome Powell’s, indication that he believes the US economy is strong enough to withstand tighter monetary policy, the S&P 500 has dropped 20% in value, proving that investors are skeptical2.
Long term interest rates on loans have also increased in anticipation of more hikes to come. The yield on 10-year Treasury bonds has increased from 1.51% on Dec. 31 of ‘21 to over 3.0% as of May 20223. Initially, long-term bond positions have seen a hit to their principal values. Over time, these bond funds will reinvest at the higher yields, thus they have the natural ability to heal themselves.
Higher interest rate environments are typically disadvantageous to growth stocks, such as technology, and require an adjustment in their valuations (price/earnings multiples). Firms that focus on consumer discretionary products, like auto manufacturers, high-end apparel producers, and sellers of durable goods, also tend to suffer during high inflation periods. We’ve seen more of these market adjustments take place since the start of the year as inflation has entered broader public consciousness as reflected by a 29% decline in the growth-heavy Nasdaq index4.
Other industries such as the financial, industrial and energy sectors might actually benefit from the higher interest rates over time. We refer to these as value investments. These sectors have often proven to outperform their growth counterparts in rising inflation environments. Energy is a standout in particular. The revenues of energy firms are, naturally, latched to energy prices, which is a key component of inflation indexes. It’s no coincidence that Exxon Mobil’s stock, for example, is up approximately 50% from where it was at the beginning of the year5. What is Encompass doing to stay on top of interest rate hikes?
Globally, with all the volatility and uncertainty, there’s a lot to navigate in financial markets. Inflation was a complication that some have been forecasting and prognosticating for some time now. What has been less expected was the ongoing conflict in Ukraine and the rippling effects through commodities markets in particular. There’s no reason to believe that this turbulence is going to ratchet down any time soon. That being said, we have a strategy we’re confident in implementing that is patient and long-sighted.
On the equity side, we recommend staying in broadly diversified portfolios, with a mix of US and international investments in both growth and value stocks. History has amply demonstrated that a diversified stock portfolio is able to withstand all sorts of global economic environments from international conflict to high inflation. While stocks can be volatile in the near-term, they have a track record of outpacing inflation in the long run. One of the worst things an investor can do is start reacting out of fear and desperation, hunting for phantom margins. Patience, humility, and cool headedness are virtues we embrace.
For fixed income investors, we recommend diversification across maturities. Within this, we’d lean towards short and intermediate duration bonds. This composition should help keep the overall interest rate sensitivity on the lower side, making it more resilient to turbulence. Short-term and floating rate bonds could benefit from the higher rates as they reinvest and adjust to the higher yields. Over the past year, intermediate and long-term bond funds have seen an initial hit to their principal values. However, these bond funds can recoup their value and heal as they reinvest at the higher interest rates, providing additional stability through broader diversification.
Investing in turbulent times is stressful. It’s one of the reasons why we are here. As a thoughtful, hardworking person with the rest of your life on your mind, there’s a good chance you don’t have the bandwidth available to offer to the nuances of a complicated market that is built on razor sharp edges. We’re here to help shoulder the responsibility providing that oft needed 25th hour of the day. You can count on us to approach wealth management as a team sport, working with you and your most important stakeholders to achieve the goals you’ve set out for yourself. As conditions continue to evolve and change, you can count on us to keep you up to date and keep you in control.