Interest rates and the stock market: What you need to know
You may have heard some chatter recently about interest rates, especially if you are following the stock market at all. If you are wondering what interest rates we are talking about and how they affect you or your investments, let’s dive in to a few things that you need to know.
What’s in the forecast?
In the past, you may have read or listened to our commentary on the business cycle. In fact, you can find our first quarter 2021 outlook on the business cycle and economy here. We often talk about the business cycle because we find that it is helpful to watch certain indicators that may explain how certain companies or industries will do over time. Last year, we entered a recession, which means that instead of our economy growing, it retreated. However, toward the end of last year, we started to see our economy get back on track and there were positive signs of growth. Those positive signals are continuing to grow stronger. This means that Wall Street is expecting our economy to continue to recover and the business cycle to move into a growth phase.
When we return to economic growth, this is called reflation. Reflation means that business activity is picking up. There is more consumer demand for commodities. Higher demand means higher prices and higher prices equal a little inflation.
Economic growth is good for stocks, right?
Yes, but not all stocks react the same. The hypothetical Wall Street playbook says that when there is a pickup in demand, the move is to sell growth stocks and buy cyclical stocks. So, what does this mean?
A growth stock is typically characterized by a company whose sales or earnings are expected to outpace the overall market or its industry. A cyclical stock is typically characterized by a company whose business is sensitive to what is going on in the overall economy.
Last year, we saw growth stocks do extremely well because the pandemic didn’t affect our demand for technology and communications. However cyclical stocks like travel and leisure, energy, luxury goods, etc. obviously didn’t do as well. Right now, the momentum is shifting.
As the economy recovers and the pandemic subsides, consumer demand is expected to continue to grow. This growing demand is felt the most in cyclical industries and we expect that prices will rise for things like hotel rooms, airline tickets, events, cars, etc. All of this results in higher earnings expectations for companies that supply for this growing demand.
Let’s use an example:
Netflix was a strong performer during the pandemic. While the world had to stay at home, Netflix continued to improve their content and provide entertainment. However, Netflix didn’t raise their prices significantly during the pandemic. They charge the same for their services regardless of the economic situation and they increase their prices systematically over time.
However, if we compare the business of Netflix to a company like Hilton Hotels. We expect that Hilton will increase their prices as there is more demand for hotel rooms. This illustrates how economic conditions can affect certain companies differently.
(This is purely an example and is not a commentary nor an analysis on the stocks of Netflix or Hilton Hotels. Clients of Centered Financial may hold these companies in their portfolio and Investors should do their own research before making any investments.)
Let’s get back to interest rates to help this all make sense.
In the news, we often hear about the 10-year U.S. Treasury rate. The 10-year treasury bond has long been accepted as the key safe haven for investor’s money. When investors are nervous about the economy and the stock market like they were in March of last year at the start of the pandemic, they typically buy more treasuries. An increased demand for the bonds will drive their price up, which in turn, drives the interest rate on the treasury bond down. However, when investors have a positive outlook on the economy and stocks, the demand for treasuries falls and in turn, the interest rate on the bonds rise.
So, what if interest rates rise?
High interest rates are good for savers, but not so good for borrowers. Essentially, higher interest rates make things more expensive. For companies, the costs associated with investing in new equipment or financing operations increase as interest rates rise. This results in decisions to decrease company spending and the result is typically lower earnings. For consumers, high interest rates result in less borrowing for buying big items like houses and cars. Higher rates also entice both people and companies to keep their money in savings to earn interest.
Rising rates can have a negative impact on the price of certain stocks.
As I mentioned above, the pressure of increased demand results in inflation (higher prices). Inflation not only affects consumers, it affects companies as well. This is because their cost of doing business goes up. In addition to higher prices of goods, rising rates makes financing things more expensive. The result of overall costs going up for a company is lower earnings.
The price of a stock is determined based on what we expect the company’s future cash flow to be. So, if we expect company earnings to be lower in the future, the stock is worth less right now.
All of this has a greater impact on high growth stocks because these types of companies typically spend a lot of money and we base their value on how well their earnings or sometimes just their sales can hold up.
What’s next? Should we get out of growth stocks?
It is important to keep all of this in perspective and focus on the long term. Growth stocks make up a very high percentage of our overall market. So, major movements in growth stocks typically result in big headlines. While it is easy to get distracted by the media, make sure to stick to your investment plan.
We feel that growth stocks are an important piece of our portfolio and we always want exposure to these types of stocks. When we see a short-term shift in expectations like we are experiencing right now, we realize that there will be some bad days for stocks, but we also feel that there are some positive things happening.
First, a selloff in highly appreciated stock prices brings valuations into a more acceptable range. In Wall Street language, we call a 10% decline in an asset a “correction”. This means that the price is corrected to be more in line with expectations.
Second, we see a selloff in growth stocks as broadening opportunities in the market. If there are attractive investment opportunities in more industries than just a select few, then this lessens the risk of a bubble. So, when there is bad news in the short-term, this may be good for the overall market in the long-term.
We don’t ever want to invest based on a passing trend. We feel that smart investing involves maintaining exposure to diversified asset classes and choosing high quality investments that meet our expectations for risk and reward. We know that values fluctuate from time to time, but we can be confident that sticking to our plan will allow us to capture the growth we need to reach our financial goals.
Other factors to consider:
Even though there is fear that interest rates and inflation are rising, we still are experiencing historical lows in both. The Fed is continuing to support our economy and they want to see inflation around 2% and low unemployment before they make any changes. They said this week that they don’t expect either of those things to happen this year. Jerome Powell, the Fed Chairman, said, “We will be patient…We’re still a long way from our goals.”
This support from the Fed is good news for the overall expectation that our economy will do well this year. In addition, we found out this week that the U.S. economy added $379,000 jobs which completely beat the expectation of $210,000. This is all good news.
So, what moves should we make?
Don’t Panic. Maintain your investment in the stock market for long term goals.
Make sure you are diversified. You need stocks that vary in their size based on valuation and stocks from different industries and different countries.
Keep some money in cash. Always keep enough money in savings for emergency reserves. As I mentioned above, higher interest rates are good for savers. We may see some higher interest paid on cash accounts soon. Also, there may be a good time to buy some stocks have come down from high values.
Consider a refinance, if you have a high interest rate. Interest rates are still extremely low. It is a good time to lock in a low rate on a long-term loan.
Stay safe and do your part to stop the spread of the virus. The market is very optimistic that our economy will recover. We need to continue to move forward and that means getting businesses back to full capacity. I think we all look forward to more travel and activities in the future and that takes all of us working together.