Making Sense of Interest Rates
Worrying is like paying a debt you don’t owe.
As inflation continues to affect many economies around the world, it is likely that we will see interest rates continue to rise as global central banks attempt to tackle this problem. When interest rates are hiked, it increases the cost of borrowing as a way to combat inflation. When loans are more expensive, companies are less likely to borrow and spend money, and individuals may postpone purchases or projects that involve financing. The goal of raising rates is to reduce the supply of money in circulation, thus cooling off the economy.
Although the MAS does not directly control interest rates, Singapore being an open and trade dependent economy will invariably be affected in some way. Over the past few months, borrowing rates and deposit rates have risen significantly with recent reports indicating that Singaporeans are on average, spending nearly 20% of their income on mortgage repayments.
Many investors worry that the present market environment of rising interest rates will decrease equity valuations and therefore lead to relatively poor equity market performance over the next year or more. From a theoretical perspective, how do these rate hikes affect the market?
For stocks, rising rates means an increase in the cost of doing business, which could lead to lower revenue and earnings and thus, lower stock prices. For bonds, when rates go up, new bonds are issued with higher coupons (improving prospects for higher future income streams), and the prices of existing bonds drop. The idea of both bond and stock prices decreasing can be alarming. But like the quote at the top of the article highlights, there is no need to worry too much about it - we will show you why.
The chart below uses data from 1954 and measures what stocks did when interest rates changed. You will see that there is no discernable pattern to stock returns when interest rates increased. There were both positive and negative returns.
Source: GYC, Dimensional Fund Advisors. The sample period is from August 1954 to December 2016 for regressions using effective federal funds rate. Stock returns from Fama/French Total US Market Index.
Other historical studies on the relationship of stocks and interest rates offers good news - equity returns have been positive on average following hikes in the fed funds rate.
Taking a period from 1983 to 2021 (a total of 468 months), there were 70 months when rates increased, and 67 months when rates decreased. There was no change for the rest of the months. The average monthly return is shown below.
With a few more FOMC meetings remaining in 2022, the Fed’s signals and actions will continue to be closely watched by the market. As they often signal what they want to do in advance, investors big and small, around the world are jostling in order to anticipate what could be happening. These actions aggregate into daily market prices. For example, the chart below shows forward interest rates traded in financial markets already pricing in a 75bps hike by the Fed in Nov, 75bps hike in Dec, with hikes gradually slowing into 2023.
These expectations are reflected in current equity and bond prices. While it’s natural to fear the future, note that financial markets adjust daily to reflect millions of investors’ expectations. Thus, tweaking your portfolio after an event is unlikely to lead to better investment outcomes.
So if you were trying to position your investments for more (or less) rate hikes, don’t do it. It is natural to worry about a worst-case scenario, and investing is not a game of certainties - we have to experience risk and uncertainty to be paid a return above inflation. However, we have shown that a diversified portfolio, especially one which is specifically tilted towards drivers of higher returns will increase your purchasing power in the long run. In a high-inflation environment, cash won’t help you keep up with the cost of living the way exposure to a portfolio of diversified stocks and bonds can.
Avoid the trap of feeling like you have to do something. Stay focused on your goals and enjoy the long-term benefits of a diversified portfolio. Transition periods like this year can be painful, but rather than focusing on the recent losses, look instead at the gains you’ve likely seen in your portfolio over the past years. If nothing significant in your life has changed, then there’s nothing to tweak in your investment plan. Trust that what you and your advisor has planned for is best for your future. If you are still unsure about how all this impacts you, come and talk to us.
