How Should Investors Prepare for a Rising Rate Environment?

Interest rate hikes are coming. There can be very little doubt about that now. Inflation has got to the point where even Mr. Transitory himself, Jay Powell, referred to the phenomenon as "frustrating" this week, and openly acknowledged that supply chain disruption is going to last longer than anticipated. When the planned $3.5 trillion of fiscal stimulus adds fuel to that particular fire, the Fed’s hands will be tied, and tighter monetary policy will have to be enacted. Based on previous statements, that may not come until Q1 of next year, but the pressure to get in front of the potential problem and act sooner is increasing.

For investors, that means that the time to act is now.

One of the biggest factors in the market strength we have seen since the spring of 2020 has been monetary policy. The Fed, by purchasing bonds in the open market, have been effectively creating investable cash. and low rates boosted stocks in two ways. They have enabled cheap borrowing that has spurred growth, but also made stocks more attractive on a comparative basis than bonds and other fixed income assets. If that is all about to change, then clearly some adjustment to investors’ portfolios are needed.

Don’t Panic

Before we go any further, though, let’s make one thing clear. Equities are still the best place to be for long-term investors. Rising rates will negatively affect stocks in the short-term and will change which sectors do well, but they will come in response to economic strength, so the long-term prospects of even some of the sectors that dip will actually be improved. This is not a time to be selling everything.

Check Your Personal Debt

In fact, the first things that every investor should be doing aren’t even related to stocks. If you haven’t already, look at refinancing your mortgage, if you have one, to take advantage of the low rates available. A quick Google search shows refinancing rates still available at around 2.5% and locking in a rate like that now makes more sense than ever. Similarly, if you have credit card debt, concentrate on paying it down now, before required interest payments start to rise.

Fixed Income

Once those basic moves have been made, it is time to look at your portfolio. If you have bonds, a move to those with a shorter-term makes sense. There are some other factors in duration, which is a measure of sensitivity to rate hikes, but time to maturity is the major one. You should also consider moving some money into floating rate bonds through ETFs such as FLOT and USFR. The yield on those funds will increase as rates rise, but the asset value of floating rate bonds is stable, so you won’t be looking at the kind of capital losses that you will see in other fixed income products.

Stocks

For most people, though, the main changes will be made to your equity portfolio, and the big thing there is to not overthink it. This is a time when the obvious is true. Not all growth companies will suffer, of course, but heavily indebted young companies that have yet to make any significant profit will be forced to rein in spending when faced with higher interest rate costs. That includes stocks such as Uber (UBER), where it will be hard to maintain growth in a rising rate environment when dealing with debt of around $10 billion and negative cash flow.

On the positive side, look at financials and commodity producing companies, such as those in the energy space.

You will hear a lot of people saying that banks are the place to be as rates rise, and while I am generally wary of conventional wisdom, I wouldn’t disagree with that. Banks make their core money from paying less interest to savers than they get from safe Treasury investments, and the spread between those two rates has been squeezed as rates have fallen. As they rise, banks can expect to make more, but the benefits won’t necessarily be evenly distributed. This is a U.S. phenomenon, so it makes sense to focus on banks with an American bias to their business. That means that regionals, rather than multinationals, would be my first choice.

Even better than that, though, are some other financial stocks that you will be hearing less about. Insurance companies take your premiums and invest them in low-risk assets, knowing that at some point they will probably have to pay some of it out. Obviously, the higher return they get on those low-risk assets, usually Treasuries, the better.

Energy and other commodity and materials industries can do well because the inflation that will prompt rate hikes will push up the price of their product. My hesitation here is that these stocks, in the energy space in particular, have already surged this year. That will limit the upside from here a bit, but at least energy and materials stocks will be less impacted by higher rates than many others.

There are other options, too. Companies with pricing power such as luxury consumer discretionary stocks obviously have an edge as prices rise, for example. However, most importantly, if you concentrate on getting your personal debt right, reducing the duration of any fixed income holdings, and moving your equity investments into less impacted areas such as financials and materials, you will be ready for rate hikes when they come.

Do you want more articles and analysis like this? If you are familiar with Martin’s work, you will know that he brings a unique perspective to markets and actionable ideas based on that perspective. In addition to writing here, Martin also writes a free newsletter with in-depth analysis and trade ideas focused on just one, long-time underperforming sector that is bouncing fast. To find out more and sign up for the free newsletter, just click here.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Other Topics

Smart Investing Economy Stocks Central Banks Markets