Portfolio Update - Feb 2022. Why it pays to stick with stocks as interest rates rise?

History tells us that the beginning of a rate hike cycle doesn’t need to be a cause for concern.

The new year has started in dramatic fashion, with investors skittish about the prospect of several interest rate hikes on the horizon.

Whereas just a couple months ago investors were doubting rates would rise until at least 2023, the situation has turned on a dime.

In fact, just a few weeks ago economists began to suspect three rate hikes might be on the cards. Now there is talk of four, five, or even seven potential increases by the end of 2022.

All this uncertainty has been weighing over the market, forcing investors to recalibrate their expectations about what lies ahead.

However, in our view, long-term investors need not worry about what might happen with interest rates in the near-term.

In fact, you are probably better served by blocking out much of this disruption as ‘noise’.

Not only does interest rate speculation serve as a distraction from the fact that wealth is accumulated over time, and stocks perform well in all cycles, but each dip in the market also represents a potential buying opportunity.

Should investors be worried about rising rates?

Much of the selling over recent weeks has been driven by concerns about stock valuations, particularly with many companies trading on high price-to-earnings and price-to-sales metrics.

As rates rise, the future value of a company’s cash flow becomes more uncertain and therefore, less attractive. Investors are prepared to discount stocks with distant profits.

This is why tech and growth stocks are traditionally hit hardest in the midst of rate hike expectations, because many of these companies tend to operate at a loss and burn considerable cash, instead investing for future growth and distant profits.

It also goes without saying that investors begin to look at alternative ‘risk-free’ options to generate returns. Therefore, when the official interest rate increases, investors can rotate into assets offering fixed-income with little to no risk.

However, we need to remember that interest rate movements can be driven by a number of factors, including what one may describe as a positive backdrop when rates begin to rise for the first time in a new cycle.

At the moment, ahead of what is likely to be the first rate hike in March, the Fed is prepared to lift rates to prevent the economy from overheating.

This problem is in some respects, a ‘good’ problem to have. The economy is growing at a rate of knots, and with employment booming, it is a positive tailwind for many stocks across the market.

Remember, the Federal Reserve will be increasing rates in order to slow economic growth and inflation, rather than stopping the economy from growing altogether.

Even accounting for a handful of rate hikes over the coming months, interest rates will still be at relatively low levels from a historical standpoint. Many would argue this is a more important consideration as opposed to the number of rate increases in their own right.

What does history suggest happens when rates begin to rise?

Rotating into more defensive assets in the face of rising interest rates comes with considerable opportunity cost, which is why investors should be very conscious about the importance of long-term investing when deciding what to do.

Let’s consider how the market has fared across recent rate hike cycles. In short, the market has a tendency to see an initial but short-lived setback as shock sets in.

The fact that a booming economy is a tailwind for many cyclical sectors such as industrials, energy, financials and materials means that the market often performs resiently, with value stocks coming to the fore both before and after the first hike in a rate cycle.

So while the S&P 500 has delivered a negative return in the one, two and three-month period after the Fed first increases rates to begin a new cycle - the average drop three months after the first rate hike in a new cycle is approximately 6% - this doesn’t last very long. In fact, you might even say that in the past this period has been a rewarding buying opportunity.

However, by month five, returns have typically already swung into positive territory, and six months after the first rate hike in a new cycle, the S&P 500 tends to average a return of 5% before picking up steam from there.

Data from the 12 rate hike cycles since the 1950s shows that stocks have risen at an average annualised rate of 9%. Of those 12 occasions, 11 of them have resulted in a positive return for the market.

If we look at the one instance between 1972 and 1974 where stocks saw a negative decline in the face of rising interest rates, there was another big issue at play. The 1970s recession. Obviously today’s environment is markedly different, with the economy on the verge of overheating - a far cry from a recession.

Another indicator comes from data produced by JPMorgan. It found that from February, 2009, the S&P 500 and 10-Year Treasury Yield moved in unison together until the 10-Year rate hit 3.5%, at which point the two metrics diverged.

At the moment, the 10-Year Treasury yield is sitting just shy of 2%. While this figure has risen rapidly over recent months, the market could still continue to rise even in the face of concerns about rising rates and increasing yields.

The lessons from this data should be pretty clear. Taking your eye off the long-term game can prompt you to make a poor decision and sell out of equities at a bad time, not only locking in losses, but missing out on potential gains as well.

Time is your friend, and as the famous saying goes, time in the market beats timing the market. One look at the charts only furthers the point, with stocks consistently showcasing an ability to rebound and make new highs time after time.

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