Rates Are Going Up: Here’s How To Play It

financial earnings

It’s been quite a while since investors had to worry about inflation, but since the election of Donald Trump, inflation is back on the radar.

Less than a year ago in July, inflation stood at a mild 0.8 percent and the Fed’s yearly rate hike still seemed almost too fast. As of March though, inflation has been at 2.4 percent and the Fed has shifted gears with two more more rates hikes and more planned before the end of the year.

But rate hikes aren’t the only problem coming from rising rates. Inflation creates a number of issues that investors will need to navigate to stay profitable.

Inflation and the Markets

The sudden emergence of inflation means that investors will need a new strategy. Historically, the effect of high inflation over the long term is still somewhat fuzzy – stocks seem to be able to eventually absorb the impact of higher rates and adjust to the new business environment. But the short term impact to the market is more obvious.

In general, rising rates means trouble for stock values. This happens because higher interest rates mean more money payed out in interest expense, making it more expensive to take out loans in order to do business. The extra expense translates to lower earnings, which means one of two things needs to happen. Either stock values fall to adjust for the reduction in earnings, or valuation multiples rise as investors essentially pay more for fewer future earnings. With the latter, it can mean a sudden bearish correction with drops of 10 percent or more in just a few weeks.

The first reaction to a possible correction might be to buy defensive dividend paying stocks, but those are likely to be the ones to under-perform first. Higher interest rates means that a dividend yield on a stock is diluted. In order to maintain the same relative payout level, the company would need to boost dividends. The same problem happens with bonds – as rates go up, bond values drop.

But there are asset classes that are perfect for a rising rate environment. Financials like insurance companies and banks tend to do well when rates start rising. For banks, higher rates translates to bigger gains on loans. Investors might think that higher rates would effectively be a wash for banks, since that means higher rates on savings accounts and CD’s, but because long term debt assets are impacted more strongly by rising rates than short term ones, banks end up profiting more.

Insurance companies, on the other hand, are required by law to keep large amounts of money in highly liquid assets in order to meet insurance payouts. Higher interest rates means higher yields on these types of accounts and boosts earnings.

 

Many investors flee to traditional safe haven assets like gold and silver, but there’s a major flaw to this thinking that could end up costing them in the long run. As an inflation hedge, gold’s true value is only realized when real rates are negative. If inflation is higher than the risk-free rate, usually based off of the yield on the 10-year treasury, then gold becomes the most valuable asset because it preserves wealth. If not, then investors would be better off in an asset with growth instead.