Inflation, Interest Rates, & Markets

January 13, 2022 – Last quarter, we discussed inflation and the possibility of rising rates. Inflation has proved to be stronger and more persistent than most expected. Additionally, as anticipated, the unemployment rate has improved. Both factors help pave the way to interest rate increases. With the markets having outperformed for the past three years, in part because of low rates, the prospect of rising rates is causing concern for some that rising interest rates will negate much of the growth they have enjoyed.  We believe there are encouraging signs for continued growth, albeit at a potentially slower pace.

The Federal Reserve sets monetary policy which, in its simplest form, influences the cost of money, as reflected in interest rates, and the volume of money, by regulating banks’ reserve requirements, to control money flowing through the economy. When policymakers perceive the economy is weakening, interest rates are lowered and the volume increased, referred to as “loosening” monetary policy. The reverse is implemented when the economy is viewed as too strong, risking inflation. The Federal Reserve “tightens” the money supply by increasing interest rates to help slow demand and bring inflation under control.  This tightening of policy is where we currently stand. In December, the Federal Reserve began winding down the program to lower long-term bond yields and talked of advancing the date to begin raising short-term rates. These are steps toward a normalization of monetary policy, following the extreme measures taken in response to the economic disruption from the pandemic.

Changes in interest rates are part of an ordinary market cycle. While normal, this tightening phase poses a challenging environment for both the stock and bond markets. When managing client portfolios, we consider the current and anticipated investing environment in order to help manage risk and still meet objectives. The markets always present risk in some form. We determine the amount and types of risks that are appropriate, and manage those risks with a focus on long-term returns.

Despite likely rate increases, the broader environment for stocks is supportive. We expect continued economic and corporate profit growth, although at a slower pace than last year. Personal and corporate balance sheets are strong with high cash levels. Furthermore, supply chain and labor problems are likely to improve as the year progresses.

Because interest rates are rising from such low levels, the primary risk to stocks during this period will likely be an increase in volatility, as well as continued internal rotations from speculative unprofitable stocks to the more traditional value sectors. In this setting, we hold on to the highest quality, profitable growth stocks, and look for opportunities in sectors that benefit from the rate cycle such as banks, industrials, and energy, or those having predicable revenues, such as healthcare. These rotations within style and sector demonstrate the importance of stock portfolio diversification.

A rising rate environment is every bit as challenging for the bond market. As rates rise, the value of existing bonds fall. The longer the maturity, the more sensitive a bond’s price is to rate changes. In managing a bond portfolio, we calculate how an individual bond or portfolio of bonds will respond to rates, and build the portfolio to suit the objective.

We continue to expect bonds to have lower returns than normal due to historically low interest rates. Even with the recent rise, we view current bond yields as too low to be consistent with a strengthening economy. In managing fixed-income, we prefer to build core positions in individual municipal bonds or high-quality taxable bonds with shorter-than-typical maturities. For diversification and added yield, we supplement these with small allocations of lower-rated and floating rate bonds, convertible bonds, preferred stock, and specialty bond funds.

How far, fast, and sustained interest rate changes will be is still unknown. The Fed controls short-term rates but can only influences longer maturities. Rates beyond the shortest maturities are set by the market, and the interest rates market is global. Ten-year rates in other major economies range from -0.2% in Germany to +0.97% in the UK, with Japan and France in between. If the exchange rate between currencies stays steady, we expect investments coming from those countries to support the prices of U.S. bonds and, therefore, hold down the yield. For that reason, in the near term, we do not see 10-year rates rising much over 2%, which limits what the Fed can do with short-term rates.

We see opportunities in foreign markets, which are several quarters behind the U.S. in rates and profits. We expect improving performance, supported by low to negative interest rates, as well as stronger corporate profits as a result of above-average global economic growth. For emerging markets, higher interest rates and higher commodity prices would be beneficial, though we are avoiding China currently. The U.S. dollar continued to strengthen through the second half of 2021, making foreign profits less valuable in dollar terms and lowering returns for U.S. investors in foreign denominated stocks.

Although we provide an overview of many areas of the market, our focus when managing your portfolio is on your personal goal and an individualized strategy to reach that goal. We welcome your feedback and questions.