Buckle Up For Breakneck Interest Rate Hikes

Buckle Up For Breakneck Interest Rate Hikes
Reda Farran, CFA

about 2 years ago6 mins

  • Interest rate hikes in the US could arrive a lot sooner and faster than expected, with Goldman Sachs forecasting a total of four rate hikes this year.

  • You can protect your equity portfolio against rising rates by swapping growth stocks for value as well as adding some bank stocks.

  • You can also cut your portfolio's bond duration, add some loans, increase your portfolio's dollar exposure, and swap gold for copper.

Interest rate hikes in the US could arrive a lot sooner and faster than expected, with Goldman Sachs forecasting a total of four rate hikes this year.

You can protect your equity portfolio against rising rates by swapping growth stocks for value as well as adding some bank stocks.

You can also cut your portfolio's bond duration, add some loans, increase your portfolio's dollar exposure, and swap gold for copper.

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New details from the Federal Reserve’s December meeting last week suggest US interest rate hikes could arrive a lot sooner than investors were expecting. Faster too: Goldman Sachs just forecasted a breakneck four rate hikes this year alone. That’s risky business for the unprepared investor, but there are six things you can do to make sure you’re not one of them.

Swap growth stocks for value

Expensive-looking growth stocks – those of fast-growing companies, like tech – are hit disproportionately hard by rising interest rates. That’s because their business models typically trade profitability today for the promise of higher profits tomorrow, and higher interest rates reduce the present-day value of those future profits.

Value stocks, on the other hand, tend to outperform in a rising-rate environment – especially if economic growth is on the rise, like it is today. That’s because growth stocks become less attractive when the overall economy is growing, since growth is, by definition, no longer hard to come by. Investors, then, start to shift their attention to cheaper value stocks: companies underappreciated by the market that could deliver decent earnings if the economy keeps improving. What’s more, while growth stocks are very much sold on the promise of their future profits, value stocks have decent profits today, making their valuations less sensitive to rising interest rates.

Where to invest: The Vanguard Value ETF (ticker: VTV).

Add some bank stocks to your portfolio

Big, diversified banks have several revenue streams, but one of the most important ones is interest from loans. And the interest rate banks charge on their loans is tied to the general level of interest rates in the economy, as dictated by the Fed. So it follows that interest rate hikes will lead to higher bank profits. What’s more, lending income is a lot more stable than investment banking income (which moves with the ebbs and flows of the economy), so banks’ overall profits should become more stable as interest rates rise. That could lead investors to assign higher valuation multiples to bank stocks, driving up their prices even more.

Where to invest: The SPDR S&P Bank ETF (ticker: KBE).

Cut the duration of your bond allocation

Duration measures a bond’s price sensitivity to interest rate changes. It’s a “weighted average” of the time you need to wait for both the payment of coupons and the return of your original investment, and is therefore linked to – but distinct from – maturity. The longer a bond’s duration, the more payments remain to be paid. The higher that figure (and therefore the more exposed the bond is to interest rate changes over time), the more its price will fall as rates rise. So one way to reduce your bond portfolio’s sensitivity to rising rates is to cut its duration by investing in bonds with lower maturities.

Where to invest: You could shift some of your existing investments in bond ETFs to the low-duration iShares 1-3 Year Treasury Bond ETF (ticker: SHY). And if you feel like taking on some more risk, you could combine your SHY holding with a short position on the high-duration iShares 20+ Year Treasury Bond ETF (ticker: TLT). That way you’ll earn the performance spread between short-duration and long-duration bonds. SHY, for example, has outperformed TLT by 4% since the Fed’s December meeting, where it announced it’s likely to raise interest rates sooner than expected.

Add some loans

The main benefit of investing in loans is that the interest rates they charge borrowers (and pay lenders) are typically tied to the underlying interest rate across the economy. That’s why they’re often called “floating-rate loans”. So if interest rates are heading higher, loan investments should fare relatively well because the interest they pay investors will also head higher. As far as fixed income investments go, loans are actually some of the best hedges against rising interest rates.

Where to invest: The SPDR Blackstone Senior Loan ETF (ticker: SRLN) is at least 80% invested in senior loans (i.e. relatively low-risk) with floating interest rates.

Tweak your portfolio’s currency exposure

Higher interest rates make a country’s currency more attractive to international savers and investors, pushing up its value. So, all else equal, higher interest rates in the US would mean a greater return on US investments, encouraging overseas investors and savers to buy more dollars to invest and save in the country. This is especially true if the Fed is the only major central bank increasing interest rates this year or if it increases them faster than others, because the dollar becomes more attractive compared to other currencies.

Where to invest: Hold more dollar-denominated investments and/or invest in the Invesco DB US Dollar Index Bullish Fund (ticker: UUP), which does well when the dollar increases in value relative to a trade-weighted basket of other currencies.

Adjust your portfolio’s commodity allocation

Gold’s macro outlook isn’t looking great this year, and there are a few reasons why.

First, like most internationally traded commodities, gold’s price is quoted in dollars. If the dollar does strengthen compared to other currencies, gold will become more expensive to buy overseas – decreasing international demand and pushing down the metal’s price.

Second, when interest rates – and, by extension, bond yields – rise, the “opportunity cost” of owning gold instead of bonds increases. Gold, after all, generates no income, which means it looks less attractive next to bonds’ better returns, causing its price to fall.

Third, gold has an intrinsic value that’s underpinned by its limited supply, which means it becomes more popular when inflation is rising and eroding the extrinsic value of money. But that also means the opposite is true: gold becomes less popular when inflation is falling. And the main goal central banks want to achieve by raising interest rates this year is to lower currently sky-high inflation. If they succeed, demand for gold as a store of value will also fall.

So a sensible option is to invest in a commodity that’s driven by long-term thematic trends as opposed to short-term interest rates changes, and copper fits the bill here. Copper’s durability and excellent electrical conductivity make it the metal of choice in solar and wind energy projects, as well as in EV charging stations, which are growing proportionately with the number of EVs on the road. As an added bonus, EVs themselves contain three to five times more copper than a conventional vehicle. In fact, the International Copper Association predicts that EV-related copper demand will more than triple by 2030.

Where to invest: The Global X Copper Miners ETF (ticker: COPX) tracks around 40 different copper-mining companies. Alternatively, a more direct way to gain exposure to the red metal is through ETFs that track its price like the United States Copper Index Fund (ticker: CPER).



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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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