How To Invest And Profit In A Rising Interest Rate Environment

10/03/2021

The stock markets have had a difficult last week. The persistently high inflation and expensive energy are driving interest rates up. Fears of a slowdown are growing. The technology sector was particularly hard hit. What is the best way to invest and profit in a rising interest rate environment?

Moods on the stock market can turn very quickly. After a calm, carefree summer with mild stock market gains, sudden sell-offs are plaguing the stock markets. September thus lived up to its reputation as the worst month for the stock market. The speed with which the market can turn is striking. Due to the concentration in trackers or theme funds, the money flows are much more bundled than in the past. Automated trading programs, which are based on the direction of the market, reinforce this trend. Everyone is going in the same direction at the same time!

The strong movements seem to be a reissue of what we experienced in March this year. The cause is the same: the rise in long-term interest rates, especially in the United States. Ten-year Treasury yields rose above 1.5 percent for the first time since June this week. That is 35 basis points more than at the beginning of August. Higher interest rates have implications for equities. Firstly, it makes the dividends and profits of stocks less attractive compared to the yield of risk-free government paper. Secondly, It increases the financial costs of companies, and thus weighs on company profits. Growth stocks are especially sensitive to interest rates. Their valuation is largely based on future earnings. Moreover, these companies have to invest a lot. With zero interest, 100 euros will be worth as much in five years as it is now. That changes if you can earn money with it risk-free through government bonds, while a higher interest rate increases a company's cost of capital. In a valuation model for a share it is quickly about a change of tens of percentages. The profits of 30 years with an interest rate climb from 1 to 1.5 percent are now worth 26 percent less.

The sudden acceleration in the yield curve is mainly due to rising inflation fears. More and more investors are doubting the central banks' claim that the high inflation we are now seeing is temporary, as it is mainly caused by supply chain hitches due to corona. But many shortages, such as those of semiconductors, persist. In addition, high energy prices are a cause for concern. Natural gas costs no less than five times more than at the beginning of this year. This also sends oil and electricity prices skyrocketing. Together with the shortage on the labor market, this is the recipe for higher wages, which can start a spiral of rising prices. And so many investors fear that central banks will turn off the monetary tap to fight inflation faster than expected. Inflation in the US has been above 5 percent for four months. Even the word 'stagflation' is being used: high inflation combined with extremely low growth or even contraction. Because economic concerns are increasing. In China, increasing regulation and the collapse of Evergrande threaten to weigh on growth. Due to the high energy price, China is compelled to turn factories on the back burner. In Europe, some sites have already closed because they are running at a loss due to the expensive energy. Factories are forced to produce less due to the shortage of parts. Meanwhile, rapid price increases are beginning to weigh on consumer confidence. In the US, family confidence unexpectedly fell sharply in September, while economists had expected an improvement.

Part is due to the resurgent pandemic, another part because higher inflation is beginning to consume part of household income. The sharp rise in house prices in particular exacerbates the inflation risk. Prices in the 20 largest US cities have risen 20 percent in one year. Normally, higher asset prices are good news for consumer confidence because they reflect a strong underlying economy. But when prices climb as fast as they are now, it could lead to a feeling that the economy is starting to get a little out of control. Housing makes up 31 percent of the US inflation basket, and enters the index with a delay of about 14 months. Due to that large weight, we see US inflation remain above 5 percent in the first quarter of 2022. Together with a relatively good job report in September, that could prompt the Federal Reserve to cut stimulus as early as November. The chance of a rise in US long-term interest rates will increase in the coming years. Then it is not a bad idea to take a closer look at your stock portfolio.

JPMorgan conducted extensive research into which sectors and which types of stocks perform better or worse than the stock market average during an interest rate climb. Financial stocks are at the top. Higher long-term interest rates support the banks' interest margins. The difference between the interest they ask to lend money in the long term and the interest they have to pay savers in the short term then increases. Insurers profit from the more generous coupons of bonds, making it easier for them to meet their obligations in, for example, life insurance. The industry is also doing well, because higher interest rates often go hand in hand with higher growth. The oil, gas and commodities companies, on the other hand, are benefiting from the higher prices for what they extract from the ground. Dangling at the bottom are defensive sectors such as makers of consumer essentials, utilities, real estate and the technology sector. In more defensive sectors, we find a lot of stocks that, thanks to their stable earnings performance, pay handsome dividends. They are often an alternative for investors looking for fixed returns in times of very low interest rates. As interest rates rise, fixed income paper becomes more attractive to such investors. On a regional level, Japan and the eurozone are doing better in a rate hike, while Wall Street and the emerging countries are underperforming. Somehow logical, because Japan and the Eurozone have more industrial companies in their main indices, the US and emerging countries have more tech stocks. Small caps also score better because they are more active in industrial and cyclical sectors.

Institutional investors have often already positioned themselves for an interest rate climb. Expensive stocks are the most vulnerable, while value stocks should perform relatively better. We remain positive for the equity markets as a whole. We see interest rates rising, but not to the level that it could structurally hurt the stock markets. In addition, it will be slow. The threat lies in an increase in long-term interest rates to 2.5 to 3 percent. We are not there yet! With bonds and cash you still lose purchasing power. Those are not options. And phasing out the monetary stimulus does not mean that the markets have to fall. Also in 2013, the so-called tapering of the Federal Reserve was accompanied by higher stock prices. Stocks offer good protection against inflation. Companies that can raise their prices see their profits rise and can increase their dividends. In addition, the companies have come out of the corona recession strongly on balance sheet. There is no debt problem. We do think that after the strong ride to the top, the upside potential of the stock markets has diminished. As a result, income from dividends becomes more important. We are not worried. The jitters in the market may be temporary and normal after the boom we have seen. That has to happen sometime. We do not think that high energy prices and high inflation will prompt central banks to accelerate their stimulus withdrawals. All in all, interest rates remain very low. Investors extrapolate a certain scenario too much, resulting in extreme price fluctuations. Fundamentally, a small interest rate hike doesn't change things.

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