The time has arrived. The Fed has finally started raising rates. It seems as though it has been forever since they raised them, but it really has just been a few years since the last time. Although that was short-lived. I thought it was worth sharing a few points about rising rates.
First, I am not going to rehash everything I wrote about a few weeks ago with inflation, mortgages, etc. However, there are a few key items to touch on once again. Before we go there, let’s take a look at what the Fed did.
Last week, the Fed announced its first rate hike in roughly 3 years. It will be .25%, better known as a quarter point. More importantly, they also basically said to expect another increase at each of their remaining six meetings this year. Odds are there will be another three increases in 2023 and then we should be done with it. Maybe. This is because a few months ago this many moves were not predicted. Continued inflation has made them more aggressive.
The instant change as a result of the increase in the Discount Rate (this is the actual place the Fed makes the change) is banks will have higher short-term borrowing costs. This means mortgage rates will go up as well as other lines of credit like credit card rates and car loans.
The whole goal of increasing rates is to take money out of the economy. Right now, and for what seems like forever, rates have been low. This means people spend less on debt payments (home loans, credit cards) and they have more money available for disposable items. Unfortunately, all this extra money has now come home to roost. Costs continue to increase and the best way to bring prices down is by decreasing the amount of disposable funds out there to spend. Simply, the Fed is forcing people to have to spend more on debt payments (this includes what businesses spend too) which then leaves less disposable money. As there will be less money out there in the “disposable economy” prices should come down. At least that is the plan.
You probably know all this already and want to know what it means for your investments. First, let’s talk about bonds, also known as fixed income. Over the last year or so, bonds have not been the place to be. At least most bonds. This is simply because the fixed income market was anticipating an increase in rates. As a quick reminder, the bond market is significantly larger than the stock market. Fewer funds were going into bonds because why buy a bond that will pay less than one issued in a few months once there is some direction about changing/increasing Fed rates. I’m not a bond expert and am not certain what the bond market will look like over the short term, but I have to imagine they like some clarity from the Fed now.
That’s all great about bonds, but most people just care about the stock market. Overall, the stock market does not mind rising rates. To an extent. I really wish I could remember the magic number I saw in a presentation years ago. That number was at what point the market stopped going up when rates rose. I think it was around 4-5%. Regardless, unlike what they may tell you on CNBC, rising rates do not necessarily mean the death of the stock market. What is more typical is a shift. And the key word here is diversification.
I mentioned in an article at some point this year how rising rates typically mean a shift of what asset classes perform better. The shift usually goes from Growth to Value. High potential/low cash flow companies do better when rates are low or dropping. Much of this comes down to the future growth and present values. Basically, when rates are zero the cost of waiting for future growth is small. When rates go up those costs to wait also go up.
This often means investments shift from Growth to Value as rates rise. Why pay more for “potential” growth when you can get actual growth from value companies who pay dividends. You know, companies like financials, energy and consumer discretionary. This is why you have seen high growth companies come down in value while companies like Berkshire Hathaway grow. Heck, it is also why International has done well recently (relatively) as international valuations are not as high as US Growth.
Ultimately, this shift is a reminder of why and how diversification is important. It isn’t saying you should try and time the market or guess which sector or asset class is going to be hot and cold. It is simply saying the market shifts and having proper representation in various asset classes is key for long-term investment success.
I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.