While higher interest rates don’t always translate to a decrease in equity prices, bond prices tend to be more universally affected and certain equity sectors may benefit more than others. International investors can hedge their portfolios by taking these trends into account.
Interest Rates and Equity Prices
Interest rates are simply the cost of using someone else’s money. Since central banks print money, they can influence these rates by increasing or decreasing the amount that they charge other banks to access money. These changes have ripple effects across the entire economy as these higher costs are passed on to businesses and then consumers. In fact, interest rates are the primary conventional monetary policy tool in use today.
Central banks use interest rates to control inflation in two ways:
- Raising rates: An increase in interest rates makes money more expensive, shrinks the money supply, and encourages consumers to save.
- Lowering rates: A decrease in interest rates makes money cheaper to borrow, increases the money supply, and encourages consumers to spend.
Interest rates primarily affect equity prices through their influence over business and consumer behavior. Raising interest rates encourages businesses and consumers to borrow less and spend less, which leads to less revenue and net income. Lower revenue and net income lead to lower stock prices and potentially lower price-earnings multiples. The opposite is true when interest rates are lowered, spending increases, and financial performance improves.
Interest rates also impact equity valuations by changing the discount rate. If the value of equity is equal to the value of all future earnings in today’s dollars, investors must apply a discount rate that represents the prevailing interest rate over the period. Rising interest rates mean that a company’s stock is not as valuable today, which would theoretically reduce the equity’s valuation and the market price at the time of the interest rate hike.
Some sectors may benefit from higher interest rates and others suffer more than others. For example, the financial industry tends to receive a boost because they can charge more for lending money. Higher interest rates lead to an increase in mortgage rates and a potentially higher net interest margin for banks. But manufacturing companies may suffer as higher interest rates tend to lead to a stronger U.S. dollar and less competitive global prices.
Rising interest rates result in lower bond prices and higher bond yields and vice versa for falling interest rates. But, not all bonds are the same. Bonds with a longer maturity tend to fluctuate more in relation to interest rates than short-term bonds. This is because interest rates that are rising are more likely to remain higher over a long period of time, which results in a greater opportunity cost when it comes to finding more attractive yields elsewhere.
The Global Economic Recovery
Central banks dramatically lowered interest rates in response to the 2008 financial crisis. In fact, many countries had near-zero, zero, or even negative interest rates. Central banks that were still experiencing a crisis then turned to unconventional monetary policy strategies, such as quantitative easing (QE) to bolster the markets and restore confidence. After several years, these strategies succeeded, and the market has stabilized to a large degree.
With full employment and signs of inflation, the U.S. Federal Reserve began raising interest rates and tapering its bond-buying programs. The European Central Bank (ECB) has similarly moved to taper its bond-buying programs.
The best historical comparison is the period following World War II. At the time, U.S. interest rates were very low, and the Federal Reserve held a large number of Treasury securities. The central bank began to hike rates in the early 1950s and inflation remained in check through the early 1960s. The 10-year Treasury yield hit just five percent, but the S&P 500 rose by about 500%, showing that equities can be resilient to rate hikes if the underlying economy is strong.
Other non-U.S. markets may experience these same dynamics as they begin to taper asset purchasing and eventually raise interest rates. It’s important to consider why interest rates are increasing rather than looking at it as an isolated event. And even if U.S. equities are holding up during a rising-rate environment, international equity markets could outperform U.S. equities if their rates are not increasing given the strength in the U.S. dollar.
The chart below shows the fed funds target rate from 2014 through August 2019.
How to Hedge Your Portfolio
There are several strategies that international investors may want to consider to hedge their portfolios.
Bond prices are likely to decline if interest rates increase in the future. One way this risk is addressed is to reduce the maturity of bond portfolios or adjust the asset allocation to favor more equities over bonds. This assumes this is appropriate for the investment objective and risk tolerance of the investor.
Equities may not be as likely to see a decline from higher interest rates, but certain sectors could gain and suffer more than others. Consumer staples, real estate, and utilities may see a contraction in valuations since their dividends are less valuable to investors, while financials and industrials could outperform as interest rates rise. Investors may want to consider sector rotation strategies to take advantage of these dynamics.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.