We are heading into a new era. An era of higher interest rates. While the US Federal Reserve has said it will lift rates ‘gradually’, there’s a possibility interest rates could be much higher in the next few years.
How should you prepare?
I’ll bet most investors think of two options when investing — bonds or stocks. While AAA bonds are more secure and reliable, stocks can provide far higher returns. But now that interest rates are rising, bonds don’t look so hot.
Sure, bond yields are rising. But that’s because bond prices are falling. Investors can now buy bonds at lower prices with the same coupon rates, hence increasing their yield. Many commentators will tell you that the bond market is nowhere near the bottom. And I suspect you’ll see much lower bond prices in the years ahead.
So are stocks the safer option?
You wouldn’t think so, from what you read in the mainstream media. This morning, The Australian Financial Review wrote:
‘Will future historians blame Janet Yellen’s extreme caution for the next massive market meltdown?
‘Champagne corks have been popping on Wall Street after Yellen, the head of the US Federal Reserve, told US lawmakers on Wednesday that she was not locked into to a set timetable for tightening policy, and that she would defer interest rate hikes if US inflation remained stubbornly low.’
The implication is that higher interest rates are bad for stocks. It’s not completely wrong, but it’s not entirely accurate, either.
Higher interest rates hinder business investment because the cost of borrowing increases. Companies also usually take on fewer investments as the hurdle rate (cost of borrowing) to fund an investment is higher.
But the two are not inversely related. There have been times when interest rates rise and so too do shares.
As Michael Foster explained in Forbes:
‘In the early 1980s, interest rates doubled from their 1978 levels over a few years—and the stock market rose 50% at the same time.’
This wouldn’t mean much if real interest rates were flat or even declined over the same period. Unlike nominal rates, the real interest rate takes inflation into account.
For example, if inflation is 2% annually and you earn 3% on a term deposit, the real interest rate you receive on your investment is 1% (3% – 2%).
Yet from 1978-82, real interests also more than doubled from 1.9% to 8.2%.
‘Then in the late 1980s, rates rose swiftly, and the market stayed roughly flat [so too did real rates]. ‘What makes this even more fascinating is that America suffered a recession at this time because of the Federal Reserve’s restrictive monetary policy. By the time the recession ended, stocks were over 20% higher.
‘The bottom line? The tired refrain that rising interest rates hurt stocks needs to die.’
So instead of listening to mainstream media noise about macroeconomic changes you can’t control, focus on what you can control — the investments you make.
If you stick to finding business that trade far below their long-term intrinsic worth, then you’ll have great returns no matter what interest rates are doing.
Junior Analyst, Markets & Money
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