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How Investors Should Plan for Higher Interest Rates

November 6, 2015, 11:00 AM UTC
Photograph by Brad Trent

On Wednesday, Fed Chairwoman Janet Yellen told the House Financial Services Committee that if the U.S. economy continues performing well, raising interest rates in “December would be a live possibility.” Though she stressed that no decision has been made yet, Mark Zandi, Chief Economist of Moody’s Analytics, says that assuming the jobs number (due Friday) “comes in at 150,000 plus, they’ll raise in December.” Following that, he predicts a slow pace of rate increases – roughly every other meeting, or three or four times – in 2016, and a more aggressive stance in 2017 and 2018 with an eventual rate target of 3.5%.

So what are investors to do? Fasten your seatbelts. “[Investors] have to adjust to this reality,” Zandi says. “The stock market is going to be very volatile. And, as rates rise, that puts significant pressure on bond prices. The only thing to do is buckle in. You’ll enjoy, at most, single digit returns for the next several years.”

History agrees with him. Robert Johnson, President and CEO of the American College of Financial Services and co-author of Invest With The Fed, has been researching Federal Reserve policy and capital markets returns for over a quarter century. Based on the availability of data, he dug into the years from 1966 through 2013 and found a dramatic difference in returns when rates are trending up versus down. When rates were trending downward, the S&P 500 returned in excess of 15% annually on average. When they were trending up, the average return was 5.9%. “Sometimes people get in the habit of looking at the absolute level of rates,” he notes. “But it isn’t so much the level of interest rates that matters it’s the direction and the trend.”

Both Zandi and Johnson believe that your reaction to this information should be based – most of all – on where you are in your trek toward retirement, in other words, on your age and your personal risk tolerance. They also offered a few specific suggestions.

  • Younger investors can ride it out. “If you have a long time horizon, there is one superior way to build wealth and that is to invest in the stock market,” says Johnson. “I always say – though I’m not sure who said it first – time in the market matters more than timing the market. If I have 20 years, I don’t care day-to-day, because I truly do have time on my side. Someone at 30, I’d argue, shouldn’t have any bond exposure.”
  • Older investors, consider beefing up your cash position. Anyone 20 years out from retirement should have a balanced portfolio with more in stocks, says Zandi. But if, on the other hand, you’re only several years away, he suggests “raising your cash position pretty significantly. If you had 5% to 10%, you should be headed back to 25%,” sometimes more. And if you’re already in retirement? “I’d be mostly in cash and dividend paying stocks,” Zandi says.
  • Pay attention to sectors that fare well at times like this. Johnson and his colleagues also dug into which stocks performed best in rising rate environments. Those that rose to the top included energy, utilities, food, precious metal mining companies, consumer goods and financials. “That all makes sense,” he shrugs. “Those kind of things are necessities. When money is more dear (when rates are rising) people aren’t going to go out and buy autos (auto tends to do poorly). They also delay purchases of durable goods like washing machines and refrigerators.” How about healthcare? “Healthcare was middling,” he acknowledged. “That surprised us a little bit.”
  • Finally, look at individual bonds rather than bond funds. The goal is to collect the coupon and lock in a real return of 1.5% – 2%, says Zandi. “That’s what I’m doing myself.”


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