Question of the Month
This is where we answer the best investment question we’ve heard all month. If you’d like your question to be considered, please send it to us.
What causes rates and inflation to rise and how does it affect asset prices?
With interest rates and inflation remaining at unprecedented lows for over a decade now, every time there’s even a suggestion of a possible increase the markets seem to go into a cardiac arrest.
All this time, several short periods of time notwithstanding, the Federal Reserve has been setting its policy to be highly accommodative, keeping the rates very low. Yet, in February the long-term Treasury yields started climbing. Why?
The main issue is the expectations of rising inflation. Inflation means that the future payments of bond coupons won’t be able to buy as much in the future as previously thought, making the bonds less valuable and, in turn, push the yields higher. The reason the inflation expectation has changed is partially because of the speed of the COVID-19 vaccine rollouts and also because of the newest $1.9 trillion stimulus bill. Globally, the IMF now expects growth this year at 5.5% vs. 3.5% last year.
Now, the bond situation may be fairly straightforward, but what often baffles even seasoned investors is how does this affect stocks. In simplest terms, the capital markets theory states that the fair value of equity is the sum of its discounted cash flows. So theoretically, you can add all the earnings that a business projects to make in the future and return to shareholders via dividends or reinvestment into the business, discounted at a certain interest rate, to arrive at today’s present value. You can debate the practical rigors of modeling these future earnings. However, when the only part of the equation that changes is the discounted rate going up, the present value of equity unequivocally goes down. A more intuitive way of looking at it is that the future earnings of a company look more appealing on a relative basis if the rates are low and less so if the rates are rising.
However, the actual impact on equities depends a lot on some business specifics, starting with the sector. Below is the chart of the typical equity price effect of the rising rates. Financial institutions are typically the biggest beneficiaries of rising rates due to the improvement of their lending rates. Other cyclicals are also typical beneficiaries, since rising rates and inflation usually mean an economic expansion, and the rise in their growth rates are expected to trump the rise interest rates. Real estate sector is more nuanced. Different types of REITs react differently to rising rates, as we explained back in November 2018 newsletter. Finally, the slow-growth defensive stocks that pay out steady dividends will be most negatively affected, since their dividends will become less attractive, much like bond interest.
Fixed income investors should consider the following hedges against rising rates and inflation:
Floating rate bonds and bank loans, which will increase the payouts as the rates rise
Short-duration bonds, which will minimize the effect of rising rates
Bond ladder, which stacks fixed income instruments of various duration with the same idea of minimizing the rate risk
Another common hedge is real assets, including residential real estate and precious metals.
However, it’s worth noting that while a threat of inflation and rising rates is real, it is by no means a guarantee, and there’s certainly no reasonable expectation of a hyperinflation. Inflation also doesn’t come without some positives. Knowing the risks and benefits can help investors avoid rash decisions and align their investments with their long-term goals and risk tolerance.