Rising Rates Causing Portfolio Volatility

Interest rates remain low by historical standards but they're finally moving up a bit. The 10

-year treasury was yielding around 1.2% as recently as August, and now is over 1.8%. (Doesn't seem like much but that's a 50% increase in less than 6 months). 30-year mortgage rates were at roughly 2.8% in August and are now closer to 3.5%.

So why are rates moving higher? Many things influence the movement of interest rates but it’s fairly obvious the Federal Reserve is a big reason rates are moving higher now. At year’s end, U.S. inflation reached 6.8%, the fastest annual rate since 1982. Barely anyone working today has any practical memory of inflation as a serious problem or threat. Inflation had remained calm for almost four decades, ever since the Federal Reserve aggressively raised interest rates in the early 1980s to combat inflation then. The Fed believes that it now must try to combat inflation again. There are two primary ways the Fed will attempt to do this.

1) Reducing the money supply. Reducing the supply of dollars, makes each remaining dollar more valuable. As the value of each dollar increases, so does its purchasing power. This slows down inflation. The Fed started reducing the money supply by slowing their purchase of mortgage bonds in December and are expected to end all purchases by March.

2) Raising interest rates. Inflation is caused by too many people trying to purchase too few goods and services. Raising rates slows the pace of consumption and investment in the economy and therefore can slow inflation. The Fed is now expected to hike rates 4 times this year, with a year-end Fed Funds Rate target of 1.0 – 1.25%. The current Fed Funds target rate is 0 – 0.25%. How does this impact your investments?

We’ve discussed the inverse relationship between interest rates and bond prices in the past. As interest rates rise, bond prices usually fall, and vice-versa. I think most investors understand that relationship. What I don’t believe that most investors understand is why rising interest rates can cause stock price declines. Rising interest rates have caused expensive high growth / high momentum stocks to come under pressure for 2 primary reasons.

1) Rising rates impact growth companies particularly hard because they typically borrow money (leverage) to grow and to fund operations. Higher borrowing costs result in lower profits or can even turn profits into losses.

2) Generally, growth stocks are more impacted by rising rates because they tend to have higher stock price valuations because investors are betting on higher projected future earnings. As an example, many high growth companies have been recently selling with a P/E (price to earnings) ratio of 40X. (The price is 40 times current annual earnings). If rising interest rates reduce profit projections (because the cost to borrow rises) by -0.1%, then the impact to the stock price would be about -4% (40x the change in earnings projections.) Rising rates result in lower expectations for future earnings and this is getting factored in to stock market prices.

Technology stock valuations have been very high in this low yield environment. The technology-heavy Nasdaq Composite has been the worst performing index recently. As I am writing this article the Nasdaq is approximately 11% below its November 19 closing high. A decline of 10% is generally considered a correction. Rising rates are causing volatility on both the stock & bond sides of portfolios.

There is some good news. While higher rates can temporarily disrupt stocks and often cause quick sell-offs, history reveals that higher rates have been associated with HIGHER, not lower stock prices. This may seem to contradict the information above but the reason is because higher rates are generally accompanied by faster economic and earnings growth. If the Federal Reserve believes that the economy is healthy enough that it no longer needs as much stimulus, shouldn’t we view that as good news? Even if the change is causing some short-term volatility.

Bottom Line: In 2022, our primary investment themes are a less accommodative Fed, and an increase in market volatility. While we are likely to see more volatility, we believe that still lingering government stimulus, a financially healthy consumer, and the eventual improvement of supply chain issues will be long term positives for the market. We believe that maintaining diversification and staying focused on your long-term risk & return goals during periods of volatility will be key in this market.

As always, please let us know if you would like to discuss your accounts and/or your financial plans.

- Brett

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