5 tips to protect your investment portfolio from rising interest rates
The economy is hot. So hot, in fact, that it is overheating.
The unemployment rate is down to a low 3.6%. Consumers have saved an additional $2.5 trillion in additional savings now vs. pre-pandemic. Earnings are up.
So what’s the problem?
These indicators are backward looking. They don’t account for the current 40 year-high inflation rate. The Consumer Price Index reached 8.5% in March compared to one year ago, arriving at a level not seen since the late 1970s. Meanwhile, prices for cars and gasoline rose 40%.
To rein in our unrestrained optimism – and the inflation that accompanies it – the Federal Reserve has said it will raise interest rates dramatically before the end of 2022.
With the right planning, your portfolio can maintain despite the radically changing conditions coming down from the Federal Reserve.
So what can you do to protect your portfolio from actions the Fed will take to reduce inflation?
- Avoid debt-heavy companies. Companies with big loans will have bigger bills to pay as rates increase, making it harder for them to balance their budgets. Instead, look for companies with low debt that can maintain earnings with little investment. Tech companies can fit that mold, especially if they have other features in this list.
- Look for companies with pricing power. Companies that have a strong market position and few competitors can raise prices as needed. One example is an MLP (Master Limited Partnership) pipeline, which basically moves oil from the well to distribution centers. Avoid utilities and railroads which tend to have debt and are heavily regulated.
- Real estate. Mortgage rates have risen off the bottom, yet remain near historic lows. If you buy now and secure a fixed rate mortgage, your monthly payments will stay at that level. For a $300,000 loan, every 1% increase means an extra $200 payment a month or an extra $2400 a year. Real Estate Investment Trusts (REIT) also deserve a closer look. Rising rents help battle rising rates. REITs have diversified in areas like data centers and cell towers, beyond the old retail and office sectors which are a lower slice of the market.
- Bonds. Thanks to their low correlation and low volatility, bonds have a place in many portfolios. Consider the coming months to be two cycles: bonds should be shorter duration in the first cycle of rising rates and inflation. If a recession starts to hit from repeated rate hikes, the Federal Reserve will pause and may even lower rates. Look for longer dated bonds in this second cycle.
- Invest in value equity and international equity asset classes. Tilting, not over-investing, in these areas during high inflation can be a smart idea. A recent Equitas study showed these asset classes perform better in times of higher inflation, perhaps because both categories start at lower price to earnings ratios than the S&P 500. History is no guarantee, but during periods of rising interest rates, we tend to see price to earnings ratios flatten out.
In short, during a time of higher interest rates and inflation, its best to own productive assets and stay away from higher duration bonds (10 to 30 years) that don’t increase payments when inflation rises.
But no matter what, investors should not panic when interest rates rise and the Federal Reserve steps in to enact changes to slow down the economy. Because what Charles Dow said back in 1900 continues to hold true – “the fact pertaining to all conditions is that they will change.”
Just make sure your portfolio is prepared to not only withstand the changes coming from the Federal Reserve, but to anticipate and work them into your investing strategy.
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