Rising Interest Rates - Things to Consider
By: David Smyth, April 21, 2017
As you know, the Federal Reserve raised interest rates recently, and we've gotten several questions from clients wondering how this could potentially affect their financial plan. The answer is that it could, and there are three areas within your portfolio to consider as interest rates are rising.
First, look at how it affects your fixed income portion. This could range from the rate at your bank (which isn't much!) to rates on Certificates of Deposit (CDs) (which are a tad higher) to increasing your returns on your bond portfolio or mutual funds.
In every interest rate environment, certain bonds will do better than others. Currently, we have the scenario where shorter-term bonds have a higher yield than longer-term bonds, simply because of where we are in the interest rate cycle. As the Fed raises rates, the gap between yields will close, but that may take many years to happen. In this current environment, you should be actively reviewing all parts of your fixed income portfolio, especially when there's a maturity of a bond, or any time interest rates rise.
Secondly, I recommend reviewing your alternative portfolio, including things like real estate, equipment leasing, commodities and natural resources. Higher interest rates typically do a couple of things for alternative investments, but eventually we're going to get to the point that it will put a stop on the real estate rally, whether on our home values going up or in commercial real estate across the country.
In addition, equipment leasing companies should benefit from higher rates, as companies are more likely to buy the old leased equipment, versus leasing new equipment at a higher cost to the corporation than they were getting a few years ago. These higher rates help the leasing companies maximize the return on their portfolio for their shareholders.
Higher rates also lead to some inflation within the commodities sector - think coffee, milk, orange juice, natural gas, etc. If it costs more to harvest the crops or get energy out of the ground, those costs are going to be passed along to the consumer. While it's no fun to experience these increases, think about it - if the cost of grain and seed is going up, then it costs more to feed a cow, and the cost of a gallon of milk (or a pint of strawberries) goes up.
Which brings me to my third area of consideration: equities. Typically, as long as we don't have runaway inflation or rising interest rates, often corporate earnings will also improve due to overall higher margins, even if the consumer isn't really noticing that their coffee costs 10 cents more, or their next set of four tires is a bit more expensive. But the company's bottom line will grow.
With those extra earnings, companies will do one of three things: they'll return the capital to shareholders as dividends; the board of directors will authorize a stock buy-back to reduce outstanding shares, making what's left more valuable; or they'll use that capital to go buy other companies. When this occurs in a particular market sector, mergers and acquisitions tend to increase, because your company could be next.
Lastly, let's assume that rising rates means economic gross domestic product is expanding. Typically this means corporate earnings are going up and the economy is starting to grow faster than it has over the last six or seven years. This may mean that certain growth-related sectors of the market could start to do better. They can maximize earnings in a robust environment, whereas a value stock may pay healthy dividends, but their income is very similar to last year or the year before, in terms of their earnings potential - think paper towels, toothbrushes, toothpaste, toiler paper, soap, deodorant. You need these things regardless of where the economy is - or at least, we hope you do!
As always, if you have any specific questions about rising rates and how your portfolio could be affected, give us a call. We'll be happy to sit down and go over it with you.