Rising Interest Rates and Its Impact on Wealth
Interest rates have been falling since the 70s, when we last saw them in double-digits. More recently, due to Covid and actions taken by the Federal Reserve, rates were cut to historic lows of nearly zero. As a society, we’ve become accustomed to this cheap cost of money, but that long-term trend is starting to reverse course.
The current inflation rate is higher than it’s been in 40 years, and it will continue to rise if no actions are taken and current economic conditions persist. In response, the Federal Reserve recently announced measures to combat these rising prices, including ending the purchase of Treasury bonds, and raising interest rates in multiple phases throughout 2022. For some, this rate hike will represent a departure from a trend they’ve known all their life.
Why Rates are Rising
Inflation rates have been rising primarily due to supply chain disruptions and shortages. Workforce and labor challenges have exacerbated these problems and impacted the availability of goods. Marketplace demand, however, remains high with strong consumer purchasing power. The invasion of Ukraine by Russia combined with the subsequent economic sanctions put upon Russia by the U.S. and many other countries are also accelerating inflationary trends – particularly in the energy and food sectors.
Raising interest rates is the Federal Reserve’s primary tool for stabilizing inflation and tempering this rising cost of goods, thus the cause for their announced increases.
Impact of Rising Rates
Higher interest rates effectively make things less affordable for borrowers and will have implications for both large and small company investors:
- Anyone with a floating mortgage (or loan) rate will soon experience increases in debt payments
- New mortgages will go up
- Rising rates will level off the prices of new homes potentially even bring them down if rates go “too high”
Implications for Investment Strategies
The previous low interest rate environment has been encouraging to individuals, especially younger people and businesses. When money is “cheap,” borrowing occurs in larger amounts. Stock prices go up and individuals are more aggressive in investments. Savers, conversely, become accustomed to little if any payment on their savings accounts or CDs. Thus, they have not enjoyed large gains and needed to incur more risk to achieve their goals.
As rates rise, there will be an unwinding from borrowers and investors to savers. Borrowing capital for projects or homes will become more expensive and difficult, and the decision to borrow more challenging. This will deter some people from pursuing projects or may cause them to abandon projects prior to completion. If rates go high enough, people won’t want to borrow at all, and instead may choose to use their own cash to avoid high interest rates.
Ways to Adjust
There is no singular way to adjust to rising interest rates, as it depends on how fast rates rise and how high they go. There are, however, some practices to keep in mind:
- Cut Down on Borrowing: Cut down on borrowing and avoid floating rate debt. If you carry debt for several years, lock in the rate to prevent expenses from rising and amassing more debt.
- Invest in the Stock Market: The stock market is generally a good inflation hedge, and the market’s return can remain higher than inflation.
- Select Stocks Wisely: Pick sectors strategically, focusing on those that perform well in a rushing inflation environment - and those who can pass off the cost to their customers. This generally includes commodities (things like oil, metal, timber, wheat), some indispensable tech stocks, and health stocks. Avoid fixed-income and high-growth stocks, as bond returns are less likely to be favorable and high growth stocks are more sensitive to interest rates.
- React to Rate Changes: Observe how fast rates go up. When the Fed whips inflation, get ahead of it by selling your inflation hedges.
- Convert to Fixed Rates: Convert floating rates to fixed rates where possible, and do so before rate hikes push floating rates up. Reconsider how your investments are allocated and diversified.
- Focus on Saving: Savers (and bank accounts) will earn better with higher interest rates in the future — consider re-allocating how you save versus how you invest.
At Richard P. Slaughter Associates, we have deep experience with the entire cycle and idiosyncrasies of rising rates. This insight allows us to guide clients in reacting to rising interest rates. Our approach is a nimble one; we continually monitor outlooks and changes to them, so we can make adjustments to keep investment plans on track. One of the biggest benefits we offer is our ability to act in an informed manner taking emotion out of the equation. This is strengthened by the long-term relationships we have with our clients. We’re able to outlast any short-term market changes and instead look comprehensively at the big picture over time. While the current events and rising rates are impactful, they are less dramatic when considered within the context of the life of the investments.