Positioning Portfolios in this Current Environment: Higher Rates for Longer?
November 23, 2022
After months of aggressive rate hikes, many investors have been asking: Will rates continue to rise?
In its latest interest rate announcement, the Bank of Canada took a “less aggressive” approach by raising rates by 50 basis points, less than its previous two rate hikes.1 However, in its November meeting, the U.S. Federal Reserve raised rates again by 75 basis points – its fourth consecutive time – signalling that it still has a “ways to go” in its tightening practices.2
Bank of Canada: Adjustments to the Target for the Overnight Rate
|Date||Target (%)||Change (%)|
Over recent quarters, we’ve been discussing the impact of rising rates on the financial markets. The central banks continue to take an aggressive approach to raising rates in their attempt to bring down inflation, which has been stubbornly high for longer than anticipated. For fixed income, investors will recall that bonds have an inverse relationship to interest rates: when rates rise, bond prices generally fall to compensate for the fixed coupon rate paid by the bond. As such, there are risks with holding longer-duration bonds during rising rate periods. For equities, valuations generally go down because the future value of cashflows is lower when a higher discount rate is used — this is especially true for the way in which growth stocks are valued. This has resulted in an unusual year for the financial markets, in which we have seen declines in both stock and bond markets.
These declines have felt particularly significant because, for much of 2020 and 2021, asset values increased with little interruption, supported by various factors: the availability of low-cost capital and use of leverage, an increased money supply due to pandemic stimulus actions and excessive exuberance. The broad-based declines in equity markets are a return to more reasonable multiples and fair value. Today’s higher interest rates have also provided more attractive yield opportunities to investors for fixed-income products. While “real” yields may not appear as significant after factoring in current inflation, nominal yields, not including inflation, haven’t been seen at these levels in well over a decade.
The Challenge of Today: Rapidly Rising Rates
Part of what makes this tightening cycle unique is the speed and magnitude at which rates have risen since March.3 Many argue that these actions have been necessary because the central banks acted too late to control inflation. However, this has also created significant volatility in the financial markets.
How have changes in interest rates and inflation historically affected the equity markets? Looking back at data for the S&P 500 since 1928, one analysis suggests that rising and falling interest rates don’t have as much of an impact on stock market performance as rising and falling inflation. The chart below shows that the performance of the S&P 500 during periods of both rising and falling interest rates hovers close to the long-term market average. However, times of rising inflation cause the markets to underperform their average. This analysis includes the high and sustained inflation of the 1970s, when then-Federal Reserve Chair Paul Volcker raised the Fed funds rate by over 20 percent to end a decade of persistent inflation. Of course, we don’t anticipate a similar situation given the more proactive actions taken by today’s central bankers. However, we should recognize that, despite the many macroeconomic challenges, participating in the equity markets has continued to offer investors the opportunity to generate positive returns over longer periods of time.
S&P 500 Annualized Total Returns During Periods of Inflation and Interest Rate Changes, 1928 to 2021
|Inflationary Periods||Interest Rate Changes||Market Average|
|Rising ↑||Falling ↓||Rising ↑||Falling ↓|
Rates are based on 10-year Treasury rates. https://awealthofcommonsense.com/2022/10/which-asset-class-is-more-attractive-right-now-stocks-or-bonds/How We Approach Portfolio Management in Today’s Environment
Though it’s never easy to see portfolio values under pressure, we expect the markets to eventually resume their upward climb. While it would be ideal to be able to hedge against the risks of inflation, rising rates, bear markets and recessions, doing so would likely lead to a portfolio that offers a limited chance of upside. As advisors, we act as risk managers using strategies to help preserve capital through these times and grow it for the future. This includes having a plan that takes into account individual goals and risk tolerance, using a disciplined approach that emphasizes quality, diversification and asset allocation and making prudent changes where necessary. Here are some of the considerations that may impact the way we manage portfolios as we endure this period of rising interest rates:
Fixed-income perspectives – During rising rate times, a bond strategy should consider shorter duration fixed-income investments. Duration is the measure of the bond’s price sensitivity for changes in interest rates, which takes into account the bond’s cash flows (coupon payments and maturity proceeds) – generally, the longer the duration, the greater its sensitivity. Shorter duration fixed-income portfolios are often impacted less if rates rise, as the reinvestment of maturities and coupons can reset the portfolio’s yield higher as these cashflows are reinvested. As interest rates peak, longer-term duration bonds become more appealing.
With increased volatility in both fixed-income and equity markets, there has been greater interest in low-risk fixed-income products like guaranteed investment certificates (GICs), which offer more attractive yields than seen in a long time. While this may be an option for cash sitting on the sidelines, we suggest that a well-managed fixed-income portfolio may offer better longer-term opportunities than investing in a GIC, especially after considering the potential tax implications on a non-registered portfolio – consider that GIC returns are taxed as income whereas a bond may have tax-preferred capital gains, such as if it trades at a discount and matures at a higher price.
Equity perspectives – Certain stock market sectors may be more sensitive to changes in interest rates. For example, in the financial sector, banks and other lenders generally benefit by raising rates for borrowers. They may also benefit from a greater spread between what they pay in interest and what they can earn on those holdings. Telecommunications and utilities are often affected by rising rates because of their higher debt loads or infrastructure costs. Yet, during challenging economic times, these sectors are often considered more “stable” as companies can have steady cashflows due to solid customer bases and limited competition. Other sectors, such as consumer discretionary, may face greater challenges as rates rise if they do not have the pricing power to offset higher costs. Today, we also see the energy sector continuing to be supported by higher oil prices, particularly resilient during this volatile period due to supply issues from the ongoing geopolitical conflict overseas.
The chart below shows the historical performance of different sectors of the S&P 500 during recent tightening cycles in the U.S. Of course, while it is important to put the prevailing economic backdrop into perspective when comparing tightening cycles, the variability of outcomes is significant.4 Generally, value sectors tended to outperform growth in the immediate period after rate hikes, though this wasn’t necessarily apparent in the period that followed. This is one reason why it is important not to react hastily by making portfolio changes too often as sector performance over shorter time periods is often variable and difficult to predict.
S&P 500 Sector Performance During Five Tightening Periods in the U.S. Since 1990:
|Months Before (-) and After (+) Rate Hikes|
|S&P 500 (Median)||4.5%||-1.6%||1.4%||11.3%|
Source: “Positioning your portfolio in a rising rate environment,” First Republic Investment Management and Research, March 2022.
Other considerations – Some investors may look to include alternative investments to take advantage of their general lack of correlation with equities and fixed-income assets. For example, private equity can provide a unique return performance (i.e., cashflow and timing) because the principal and gains are distributed as investments are realized. Other alternative investments, such as real assets, are often seen as a hedge against inflation and may perform well during rising interest rate times.
The Importance of Diversification and Quality
Given that different asset classes act differently depending on changing circumstances, this points to the importance of diversification and quality as we manage investor portfolios. The goal isn’t to invest solely in the top-performing sector or asset class each year; this is largely unpredictable as markets and economies can take many different paths over the short term. Consider how quickly the macroeconomic landscape can change – the aggressive nature of the central bank rate hikes was not easily predicted at the start of the year. A well-diversified portfolio allows access to the top-performing sectors or asset classes, while helping to protect from downward pressures that may affect sectors and assets classes at different times. Equally important is a focus on quality. Corporations with strong balance sheets, low debt and stable cash flows are often better prepared to sustain their operations through challenging economic times. Those who consider quality investments may also worry less about enduring values during uncertain times, knowing that price setbacks are often temporary.
What is the Path Forward?
The central banks have focused on achieving “price stability” and preventing inflation from becoming entrenched. We are seeing the effects of the rate hikes start to take place, such as with the cooling of rate-sensitive areas of the economy like the housing market. Yet, it will take time for inflation to substantially ease. As such, we anticipate that the central banks will continue to raise rates over the near term with the ongoing intent of slowing economic growth. For the financial markets, we foresee continued volatility.
It has been a difficult year for investors and the current and evolving economic environment may feel uncertain. The days of easy monetary policy that supported rapid equity gains are behind us. We suggest that patience, alongside thoughtful analysis and a disciplined approach to investing, with our support, remains important when investing with the longer term in mind. It’s worth repeating: periods of retrenchment are part of the natural cycle, but they have always been followed by new growth, economic expansion and improved equity values. As always, should you have any questions about this or any other investing matters, please get in touch.
1. The rate hike on October 26, 2022 of 50 basis points was lower than the previous 75 basis point increase in September and 100 basis point increase in July. https://www.bankofcanada.ca/2022/10/fad-press-release-2022-10-26
2. “Fed Lifts Rates, Signals ‘Ways to Go’,” The Wall Street Journal, November 3, 2022. Front Page.
4. How assets respond to rising rates can vary by tightening cycles due to the prevailing economic backdrop.