In 2020 alone, the U.S. Federal Reserve pumped more than $3 trillion into the economy or roughly 20 percent of its existing money supply. The goal of this unprecedented move was to combat the devastating impacts of the pandemic. However, its future implications on the economy are yet to be determined. While the Fed has ensured everyone that they do not expect hyperinflation to occur, the tsunami of money that’s flooded into the economy has left many investors worried about rising debt and inflation.
We’ve seen this fear ripple into the stock market in early 2021 as investors flocked toward value stocks, such as banks and cyclicals, and rotated out of tech and other growth stocks. In the last few months alone, I’ve seen my gains over the past year drop in the high double digits due to the rotation out of high-growth stocks.
As the pandemic rages on with no end in sight, it begs the question – will the threat of hyperinflation impact interest rates?
- Contrary to what we think, high-interest rate environments typically occur during economic booms rather than recessions.
- The losers in a high-interest rate environment are (1) highly leveraged firms/debt-intensive industries, (2) exporters, (3) individual debtors and new borrowers, (4) bond and bond fund owners, and (5) commodities.
- The winners in a high-interest rate environment are (1) cash-rich companies, (2) banks, (3) healthcare and technology companies, (4) energy companies, (5) individual savers and retirees, (6) short-term or floating rate bonds, (7) brokerage firms, and (8) real estate.
Understanding High-Interest Rate Environments
When we think about rising interest rates, we often associate them with recessions. However, that is far from reality. Federal interest rates tend to increase during economic booms because people feel more confident about taking out loans. That includes credit cards, mortgages, business endeavors, student loans, etc. During recessions, money is tight, so people are less interested in borrowing and more focused on survival. Hence, the Federal Reserve focuses on lowering interest rates to stimulate the economy and encourage people to spend money.
At a basic level, interest rates are affected by the supply and demand of credit. When demand for credit rises, interest rates rise. When demand for credit falls, interest rates fall. Conversely, when the supply of credit increases, interest rates decrease, and interest rates increase when the credit supply decreases.
Though the supply and demand of credit play a significant role, inflation can also affect interest rates. When inflation rises, interest rates are more likely to increase. As the value of money decreases with inflation, lenders will seek higher interest rates as compensation for a loss in future purchasing power.
Investing in a high-interest rate environment comes with its own risks and rewards. As we wade through this possibility, let’s go over some losers and winners in such an environment.
Losers in a High-Interest Environment
If and when the Fed raises interest rates, people will get hurt by this decision. Here is a brief primer of those who will potentially get negatively impacted when borrowing becomes more expensive.
Highly Leveraged Firms/Debt-Intensive Sectors
Companies or sectors saddled with debt will be some of the biggest losers during times of rising interest rates. The more debt they have, the higher their debt servicing costs and risk of default. To offset potential costs and mitigate risks, investors will be more likely to sell positions in highly leveraged firms they’ve bought on margin.
During times of high interest rates, look closely at companies that have taken on a lot of debt to finance their operations and future growth as they are more likely to underperform. Typically, this would include capital and debt-intensive industries, such as telecoms, construction, manufacturing, utilities, shipping, and REITs.
When interest rates rise, the value of the U.S. dollar appreciates relative to other currencies, which affects exchange rates and international trading. Let’s use the U.S. dollar as an example – when the dollar is weak, that stimulates exports, and imports become more expensive. But, when the dollar is strong, that hurts exports, and imports become cheaper. U.S. companies who rely on exports get adversely impacted because their goods will be more expensive compared to their international peers, thus making them less competitive.
For example, the U.S. has long accused China of being a currency manipulator to boost its exports at their expense. While the Chinese government has taken a much more active approach to managing its currency, note that the IMF determined that the yuan was fairly valued in 2019.
Individual Debtors and New Borrowers
Similar to highly leveraged companies and sectors, rising interest rates push up the costs of borrowing for individuals, whether it’s credit card debt, mortgages, student loans, auto loans, etc. If you have a 30-year low-interest mortgage rate locked in, then you’re probably in the clear. However, if you are looking to finance purchases with debt or hold adjustable-rate mortgages, you’ll feel the pinch more.
Mortgages usually get pegged to the 10-year Treasury bill. Though this rate isn’t directly controlled by the Federal Reserve, when the central bank sets higher short-term rates, long-term rates will likely rise as well. On the bright side, because global investors use Treasuries as a safe haven, high demand for yields will hold them down. When there’s bad news, they will rise in response. So, even after interest rates rise, mortgage rates might rise slower.
Bond and Bond Funds Owners
If you follow the classic 60/40 portfolio of 60% stocks and 40% bonds, you may get negatively impacted by rising rates. The bad news with this portfolio allocation is that bonds and interest rates have an inverse relationship, so when interest rates rise, bond prices fall. If you are overexposed to specific types of bonds, you could be vulnerable to losses.
Bonds generally pay a fixed coupon, so when rates rise, the value of your bonds falls until its yield matches whatever is available on the market. How much you lose will depend on how much the rates rise, the maturity, yield, and other features of your bonds. To determine how sensitive your bonds are to interest rates, look for a bond fund’s average portfolio duration. The duration will tell you how much you can expect to lose for each 1% increase in rates.
When rates increase, the coupon return for intermediate and long-term bonds gets erased. To offset potential losses, investors may want to focus on shorter-term government bonds instead. While older bonds may get adversely affected, newer issued bonds will pay out more money to investors because they will generally offer higher yields.
Historically, commodities and interest rates have had an inverse relationship due to the cost of holding inventory. When rates rise, commodity prices tend to fall because it becomes more expensive to store raw materials, thus reducing incentives to carry additional inventory. When rates are low, holding raw materials is much cheaper.
Commodities such as oil and gold have historically been used as inflation hedges. Many investors argue that they outperform with rising interest rates and have a high correlation to inflation rates. However, recent findings indicate that gold may not be the perfect inflation hedge after all.
Winners in a High-Interest Environment
That’s enough with talking about the losers in a high-interest rate environment. We’re all here to make money and build our wealth, so let’s go over some winners.
Companies sitting on a lot of cash will benefit from rising rates as they earn more interest income on their cash reserves. Companies with plenty of cash and little to no debt get perceived as less risky during these times. Investors seeking safety may gravitate towards cash-rich companies. Look for companies with low debt-to-equity (D/E) ratios or companies with much of their book value in cash form.
However, note that having too much cash on standby is not the best use of capital as it is not getting used to expanding and growing the company. The longer-term fate of cash-rich companies will depend partly on how efficiently they are using their capital.
Currently, banks make money by borrowing (from our checking and savings accounts) at low short-term interest rates and lending the money out at higher, longer-term rates. In the perfect world, they would have dirt cheap short-term rates and high longer-term rates.
However, long-term rates are relatively low while short-term interest rates are stuck at zero. That leaves little room for banks to make money off the “spreads” or the difference between the two rates. With higher interest rates, banks stand to make more money from better spreads.
Banks and other financial institutions usually earn more with higher rates because that allows them to receive bigger margins and more profits from loans and transactions. However, real estate or home construction companies lose out when interest rates rise because people are less likely to borrow money.
Healthcare and Technology Companies
As we mentioned earlier, interest rates usually rise when the economy is getting stronger and growing quickly. A stronger economy bolsters the technology and healthcare sectors and their bottom lines. Additionally, technology and healthcare companies typically use their additional profits to reinvest in their growth rather than pay shareholders dividends, which helps them grow faster.
History shows us that in times of rising interest rates, this move brings in increased revenues. Over the past 13 rising-rate environments in the last 64 years, the tech sector gained an average of 20% while the healthcare sector gained 13% over a one-year period following the first interest rate increase of each cycle. Compared to the S&P 500’s average gain of 6.2%, this is a significant difference.
However, much of future performance in these two sectors depends on current valuations and expectations. Many investors believe that high-growth tech and healthcare stocks are overpriced and vulnerable to sell-offs. For example, companies like Enphase, Tesla, Square, and Crispr Therapeutics are trading at insane price-to-earnings (P/E) ratios.
The energy sector is another major winner when interest rates go up. No matter how strong or weak the economy is, everyone still needs to consume energy. In both rising and falling interest rate environments, energy companies are solid performers with 12.1% returns during falling rates and 10.1% returns during rising rates between 1966 and 2016. During the same period, the S&P 500 returned 15.2% during falling rates and 5.8% during rising rates.
However, there are some risks for oil stocks in particular. When rates rise, the dollar becomes stronger, putting downward pressure on oil prices and stocks. In addition, international politics can also adversely affect oil prices.
Individual Savers and Retirees
When the Fed hikes rates, it may be time to increase your savings rate as rising rates can translate to higher interest rates on your savings account. The more cash you store away in your savings account, the more interest you can potentially earn from your bank. Having some cash on the side also allows you to buy more securities if there are any sell-offs in the markets.
Retirees with fixed incomes can withdraw from their investments and savings at a higher rate more confidently without having to worry about running out of money. Higher interest rates allow you to earn a bit more for every dollar invested on financial vehicles such as certificates of deposit (CDs) or money market accounts.
Short-Term or Floating Rate Bonds
If you are a bond investor looking to decrease portfolio volatility, consider moving some of your capital into short-term bonds or purchasing bonds with coupon rates that move, or “float,” with the market rate. Short-term bonds have a shorter maturity structure, while floating-rate loans adjust with short-term benchmarks. These factors make them less sensitive to changes in interest rates.
Some examples include the Vanguard Short-Term Bond Fund (VCSH), iShares Floating Rate Fund (FLOT), and Treasury Inflation Protected Securities (TIPS). During periods of rising rates, these types of securities will be more stable and resilient.
Many major brokerages, such as Charles Schwab and E*Trade, earn interest on cash sitting in customer accounts. When rates rise, they will naturally earn more interest from a more favorable revenue spread. When federal fund rates rose from 1.25% to 2.25% from 2003-2004, both brokerages had a 38% increase in interest income and a 10% improvement in operating profit margins.
However, as a result, there has been an ongoing debate about Charles Schwab’s “free” robo-advisory service. Many investors argue that Charles Schwab’s service is technically not free because they make money off of the spread by recommending customers to hold 8-30% cash in their accounts.
The prices of real estate tend to rise with, or even outpace, interest rates. To profit during a rising rate environment, consider buying real estate or investing in real estate investment trusts (REITs), such as Fundrise. While new investors may get negatively impacted, investors who plan ahead can make considerable gains. Real estate and REITs tend to outperform when investors anticipate rising rates because they benefit from the economic growth that typically occurs alongside rising rates.
The Bottom Line
Investing in high-interest rate environments requires multiple lines of attack and defense. No matter what your investment objectives are, we all need to take steps to limit the negative impacts of rising rates while continuing to grow our wealth.
To stay on the winning side during a high-interest rate environment, consider:
- Investing in companies flushed with cash
- Finding companies in sectors that are likely to flourish, such as tech, healthcare, and energy
- Increasing your savings rate
- Purchasing short-term or floating rate bonds
- Dabbling in real estate