What a Rise in Interest Rates Means for Your Portfolio
How the Market's Changing Climate Is Affecting Your Investment Portfolio
Interest rates are on the rise. That’s more than a financial news headline. It could have a real impact on your investment portfolio.
Interest rates have increased a full 1 percent over the past 5 months since hitting an all-time low in July. Much of that rise was prompted by Donald Trump’s election, as the markets expressed a belief that Trump’s proposed economic policies would spur both economic growth and inflation.
There is also a widespread sense that these rising interest rates will usher in a bear market for bonds. That makes sense. When rates rise for an extended period bond prices decrease, as the two move in a seesaw pattern. 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.
What to Do When Interest Rates Go Up
Big rate gyrations, in both the short and long-term, can significantly impact the balance in your portfolio. And, as in tightrope walking, balance is critical to success in investing. So, what moves should you make now that interest rates are drifting upwards?
Interest rate movements are notoriously hard to predict. But it seems likely that rates will drift higher over the next few 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.
But look for interest rates to then level off as investors realize there’s not a structural inflation problem yet, as real GPD and wage growth are simply too low to keep driving up prices. In the longer-term, we may see a slow upwards slog as economic growth is limited by slow population growth and the debt that still limits many families’ ability to make large purchases.
Of course, there comes a point in our always-cyclical economy when higher interest rates become a bad thing. No one can pinpoint that exact level, but many economists put it in the 3 percent-3.5 percent range. Beyond that, 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. As proof, November was the worst month for bonds in 12 years! But keep that in perspective. The aggregate bond index fell 2.4 percent. Stocks are much more volatile. The S&P’s worst monthly performance in 12 years was a 16.9 percent slide in October 2008. The worst so far in 2016? Down 5 percent in January. This is why you should own bonds: For consistent income and to dampen portfolio volatility. In periods of uncertainty, like the current post-election transition period, bonds really earn their keep.
Stocks, on the contrary, will generally benefit from rising rates as they suggest stronger economic growth. Cyclical industries such as financial institutions, industrial companies and energy providers will do better, while the RUST — REITs, utilities, consumer staples, telecommunication — sectors of the stock market will likely dip.
The Bottom Line
The answer to how you should be investing in the current climate is very Zen. You should invest the same way you should always be investing. That means building 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. To borrow a line from the movie Benjamin Button, we never know what’s coming for us. The best we can do is mindfully manage our portfolios to limit the downside and increase potential upside as the market goes about its unpredictable business. Diversification is the best way to do that — regardless of where rates are headed.