You may be in pain with rising interest rates if you’re like the typical investor with a 401k portfolio of all stocks or the traditional 60/40 (60% stocks/40% bonds) portfolio.
On Wednesday, the Federal Reserve voted to lift interest rates and penciled in six more increases by the end of this year. The Fed’s decision to raise rates was a complete about-face from its policy stance from June 2020 when it indicated that it intended to keep rates near zero to promote employment.
“We’re not thinking about raising rates. We’re not even thinking about raising rates,” said Fed Chairman Jerome Powell.
Why the change? One word: INFLATION.
The rationale behind raising interest rates and increasing the cost of borrowing to slow demand is that the pace of rising prices will slow as well. It’s a bitter pill because lowering demand will affect company bottom lines, which theoretically will impact stock prices.
Lower profits because of slowing demand is not the only way rising interest rates negatively impact stock prices. Theoretically, the stock price is based on the net present value of a company’s future income streams. A higher discount rate means a lower current value and a lower stock price.
Besides the financial implications of rising interest rates on company bottom lines and stock prices, there’s the negative perception held by retail investors of rising interest rates. In short, investors are spooked by rising interest rates. So, there’s that additional element to add to the portfolio performance mix. The bottom line is rising interest rates are not good for a traditional portfolio.
Where does an investor hedge to offset rising interest rates?
Cash-flowing tangible assets have always been a favorite of ultra-wealthy investors for protecting their portfolios against the diminishing effects of inflation, and the rising interest rates used to combat it. Why?
Cash flow like rents from commercial real estate typically rises with inflation – thereby protecting income against diminishing buying power. A typical salary will not increase concurrently with inflation. That take-home pay is continually eroded as the cost of goods continually rises.
We’ve heard of record increases in rents and real estate prices in the past two years, but nothing about rising wages. If you have income tied to rents that rise in sync with inflation instead of income tied to a job, then the destructive effects of inflation can be neutralized. On top of that, the underlying value of the real estate will rise with inflation as well.
On top of the rents and values that correlate with inflation, real estate holds one additional advantage over traditional portfolios: the debt servicing hedge.
Real estate acquired with fixed financing locked in for years locks in low-interest rates and keeps debt servicing stable while future rates are guaranteed to rise.
Rising interest rates will be a bitter pill to swallow for investors with traditional portfolios. It won’t be for all investors. Investors allocated to cash-flowing assets – especially assets that thrive in downturns or inflationary environments – are best equipped for dealing with inflation and the effects of rising rates.