We know that inflation has a grip on most western economies at the moment. As a result of this central banks around the world are increasing interest rate. This includes the U.S Federal Reserve who have recently begun rate rises from their recent historical lows approving a 0.25% raise in March and a 0.5% raise in May.
After having interest rates artificially low for a long time, investors kept funnelling money towards high growth investments and were handsomely rewarded, including riding out and exceeding the brief COVID dip. Tech focused funds like Cathie Woods Ark Innovation Fund amazing returns such as 170% for 2020 and basically couldn’t miss. After 2021 rolled in, inflationary concerns grew with fears of substantial interest rate rises and investors began to slowly sell out of growth themed stocks and funds. This only accelerated towards the end of 2021/early 2022.
Now investors are dealing with an increasing interest rate environment and finding quality share market investment returns is going to get a lot harder.
With the changing economic backdrop, we discuss 5 ways to profit thanks to the U.S Federal Reserve rate hikes.
1. Invest in quality companies that actually make a profit
As mentioned above, prior to early mid 2021 companies in the tech sector or managed funds with a high growth focus performed really well compared to other investment sectors, easily outperforming value style companies and managed funds. Typically these growth investments were in companies that were young companies with limited revenue and in a lot
of cases no profit. Investors were buying into the blue sky potential of these companies.
Growth investing has a more long term focus and these shares tend to pay no or little dividends to their investors. These companies tend to need significant borrowings or rounds of funding to keep growing. This is great when interest rates are dropping or stable. When interest rates rise this can cause problems to the valuations of these companies.
Value investing underperformed at times through the late 2010’s through to the end of 2021. An example of a value style investment is Warren Buffett’s Berkshire Hathaway. One of the typical fallouts in an increasing interest rate environment is high growth styled companies that rely on significant borrowings to fund their operations can be subjected to significant sell offs in a rising interest rate environment. Even established tech companies aren’t immune. Take the recent sell downs in Netflix, Amazon, Alphabet (Google), previous market darlings whose recent share price has been hammered as interest rates started to rise.
Since the beginning of 2022, the tech focused Nasdaq 100 index has lost over 25%!
In contrast, typical value style companies and funds (such as Berkshire Hathaway) have performed quite well (compared to the general market sell offs)
2. Review any potential bond investments (avoiding long duration bonds in particular)
A rising interest rate environment can be a mixed bag for bonds. Longer duration bond values can be decimated while shorter duration bonds could see a boost. The trade off here is that the income from the shorter term bonds is usually less than the longer term bond. If you were looking for a longer term fixed interest investment it might be worth looking at an investment that has a floating rate debt (such as a bank loan).
Alternatively you could move your fixed interest allocation towards a lower risk value style portfolio (with substantial dividend yield) or look to invest in a diversified real estate fund (also with a decent yield).
3. Review your current portfolio and reduce or eliminate your current high growth or tech exposure
If you have growth orientated shares, be prepared for significant under performance in a higher interest rate environment. If your investment time frame is long term (i.e. 5-7 years) and you still believe in that particular company then you may want to keep that investment. Alternatively if you were only investing for short term grow or to hold shares for a shorter term it might be in your benefit to move away from the high growth/tech focused investments to value style investments (at least in the short term). One thing to note that given the substantial drawbacks in some sectors (as mentioned above the Nasdaq 100 is down over 25% in 2022) we may be approaching a market bottom at which time the current market situation becomes a great buying opportunity.
Given that it’s a fool’s game to time market tops or bottoms another alternative is investing a regular amount per week/month/quarter also known as dollar cost averaging.
By investing a regular amount into the stock market during down periods such as the current environment you are picking up some quality investments at a significantly reduced valuation.
4. Look for companies that should benefit from rising interest rates
This is pretty obvious however look at companies such as banks who should benefit.
As interest rates rise, the spread between the cost of borrowing (i.e. deposits) and the interest rate they charge borrowers tends to grow. If investing look for banks that have most of their business from the country with the higher interest rates. What about companies that could benefit on changes in consumer spending? Could people downsize their properties into apartments or cheaper cities or towns to reduce mortgage costs? Could people purchase cut price grocery brands rather than the more luxurious brands?
On the flip side avoid companies that will struggle in a higher interest rate world. Aside from the high growth stocks mentioned previously companies look at whether people will purchase a particular item when interest rates rise. Will people purchase a new car if interest rates conti8nue to go up, will people look at building a new house if interest rates keep going up? Will people buy luxury items if interest rates keep going up as more money will have to go towards paying mortgages?
5. Pay down your own personal debt and fix any variable rate loans that you owe
If you currently have a home loan on a variable rate it may be time to review this and possibly look at a fixed rate option, or maybe part fixed/part variable (if that option is available) Particularly if you have a home loan that is a variable rate you want to reduce this as soon as possible.
If you think rates are going to rise significantly then lock in a fixed rate. If you got in early and locked in a fixed rate in late 2021/early 2022, well done! If not and you don’t think rates will rise too much more then you may want to stay at a variable rate and just focus all surplus to paying down the loan.
Alternatively if you think inflation is here to stay a while and interest rates need to go up significantly more then it might be worth locking in a fixed rate. Bear in mind that most lenders have already built in potential rate rises in the fixed rate offerings so do your sums before making any commitments.
Regardless of which way you go any surplus funds that you do have, direct all these to paying down the loan as soon as possible.
Just because interest rates are rising doesn’t mean that investment opportunities don’t exist. It just means you will have to put in a little more research than you may have had to do.
One point to bear in mind regarding investment strategies for a higher interest rate environment is that higher interest rate environments can be accompanied by higher inflationary periods. Investing in an inflationary environment has its own nuances and needs to be thoroughly researched. We’ve only focused on investing in a higher interest rate environment only, not one that is also accompanied by a higher inflationary environment.