The Federal Reserve has embarked on a major campaign to try to contain inflation. The Fed has already made a 25 basis point hike, a 50 basis point hike and two 75 basis point hikes. This latest increase in May was the largest since 1994. Analysts now expect us to end the year close to 3%.
Fed Chairman Jerome Powell has made it clear that the current rate of inflation is unacceptable and that the Central Bank will continue to take aggressive action to eradicate it. This accelerated rate hike campaign has been a major contributor to the stock market’s uneven performance over the past six months. Let’s zoom out though: what do higher interest rates mean for equities and what can investors do to prepare?
First, the bad news
Overall, the effect of rising interest rates is negative for the stock market. It’s an old adage that traders shouldn’t fight the Fed after all. When the Fed raises interest rates, it actually reduces the amount of liquidity in the financial system. This acts as a sort of gravity that drives most of the assets. When you withdraw dollars from the pool of capital circulating in the markets, you usually see a decline in the market for housing, stocks, cryptocurrency, etc.
The effect is particularly pronounced in so-called long-lasting assets. These are investments that produce little or no profit or cash flow today. On the contrary, the value of the investment comes from the potential for considerable growth in the years to come.
In a world of zero interest rates, there was little opportunity cost to own Bitcoin (BTC-USD) or a hot cloud SaaS business. After all, it’s not like the bank pays interest on savings accounts. So why not target the stars with more speculative investments?
Now that interest rates are rising dramatically on fixed income investments, however, there is a much clearer trade-off. People can suddenly get significant cash flow by buying bonds. Additionally, certain investments in areas such as energy and commodities pay huge dividends. There is suddenly a much greater opportunity cost to owning a cryptocurrency or tech stock that is not producing profits or paying dividends today.
It is precisely for this reason that the Fed is the main driver of the deflating of asset bubbles. By making it more expensive to invest in speculative assets, rising interest rates tend to stifle investor enthusiasm.
In other words, a cycle of Fed rate hikes requires investors to act cautiously. But this is not a death knell for the market either.
Beneficiaries of rising interest rates
Certain segments of the economy can directly benefit certain stocks and sectors. Banks, for example, make money from the difference between the rates they get on loans such as mortgages and the rates they have to pay depositors for savings accounts, checking accounts , etc.
Typically, in a rising rate environment, banks are able to collect a larger spread between these rates, leading to increased profitability. A bank like Goldman Sachs (NYSE:GS), for example, currently trades at just 9.4 times forward earnings and offers a reasonable dividend yield.
Another beneficiary of rising interest rates are brokerage firms such as Charles Schwab (NYSE:SCHW). Brokerages typically pay little or no interest on their customers’ cash deposits. But they are allowed to invest client cash in fixed income products. Thus, soaring interest rates create a significant additional profit stream from this idle cash for the brokerage industry.
A third winner in a rising rate environment may be commodity and energy companies. In many cases, as we are seeing now, higher interest rates are directly linked to higher inflation and soaring commodity prices. As long as the current inflationary wave holds, businesses such as oil and gas producers, fertilizer makers, and copper and iron ore miners should perform well.
The 60/40 Portfolio
Traditionally, many financial advisors have offered a variation of the 60/40 portfolio as the ideal combination. This is a portfolio made up of 60% equities such as the S&P500 Where Nasdaq index funds and a 40% allocation to bonds.
Bonds and stocks tend to have a fairly low correlation between them. Bonds often rise in price during tough economic times as people seek the safe haven of fixed income securities. Meanwhile, stocks tend to rally during strong economic times. Thus, these assets play off each other, with one tending to perform well when the other is underperforming. With constant rebalancing between stocks and bonds in a portfolio, investors can take advantage of this momentum to smooth and enhance their returns.
How does this effect impact things in 2022? Right now, bonds have fallen dramatically. Remember that when interest rates go up, that means bond prices go down, and vice versa. Thanks to the rapid economic recovery since 2020, economic activity and inflation have surged, reducing demand for bonds.
This caused the iShares 20 Plus Year Treasury Bond ETF (NYSEARC:TLT), which holds long-term US government bonds, to plunge this year. TLT is down 21% year-to-date and is now trading at 2018 prices. This could make this an interesting time to buy bonds and offset a portfolio’s equity exposure.
To be frank, on the whole, higher interest rates are negative for stock market investors. However, it’s not necessarily as bad as some experts claim. While certain sectors such as technology generally fare poorly in a rising rate environment, a tactical investor can find significant opportunities in a higher interest rate environment.
As of the date of publication, Ian Bezek held a long position in GS stock. The opinions expressed in this article are those of the author, subject to InvestorPlace.com publishing guidelines.