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Should Investors Fear Higher Interest Rates?

February 1, 2017 | David G. Sparks, CFA

Maybe higher interest rates would not be so bad for investment portfolios and the economy. It’s a thought worth exploring as the both monetary and fiscal policy under the new Trump administration seem to be pointing in that direction.

Now it is true: bond prices decline when interest rates increase, holding all else equal. This effect may produce a loss of market value at first. But investors can preserve their opportunity to earn the yield they paid for by choosing to hold bonds to maturity. And reinvesting bond interest payments at higher-than-anticipated yields can increase future wealth compared to original expectations.

Investors who have been keeping their maturity dates relatively short-term, as we have preferred to do in managed portfolios, may see two benefits. First, short-term bonds may not decrease in price as much as longer-term bonds do when rates rise. Second, investors may be positioned to reinvest principal sooner at higher yields.

Our eyes are open to the possibility of moving bond maturity dates farther into the future to capture higher yields, especially if longer-term rates rise faster than short-term rates do.

The impact of higher rates on stocks can be harder to predict. Interest rates can move higher in two different ways, and the effect on stocks in the past has been different depending on which path rates follow.

Rates can move higher because real growth in the economy accelerates. Greater demand for goods and services can translate pretty quickly into greater demand for investment capital, pulling interest rates higher. Those conditions are typically good for business also. A long period of rising rates in the 1950s and 1960s was driven by growth and rewarded patient, long-term investors in stocks.

The other path toward higher rates is driven by inflation. The correlation of bond yield levels to inflation has been quite high in the past. It makes sense. Investors would reasonably require higher returns to keep their interest income rising at least as fast as the cost of living.

An unexpected surge in the price of goods and services can knock businesses for a loop.  They may struggle to pass increased costs through to consumers while managing potential fall-off in demand for their products. There is even a name for extreme cases of economic stagnation occurring during high rates of inflation: stagflation. Stock markets have not responded favorably to those developments, as investors painfully learned in the 1970s.

High valuation levels prevailing in stock markets today could exacerbate the initial, adverse effect of a sudden rise in the rate of inflation or an unexpected lapse in economic growth.

Consumer prices roughly doubled during the 1970s, while major stock market indexes ended the period roughly unchanged from ten years prior. Again, patience was rewarded. Stock dividend yields well above today’s bond yields made it a bit easier to hold on. And capital appreciation turned out to have been only delayed, rather than denied.

Corporate earnings can catch up with inflation. Then, when inflation rates begin to stabilize or decline, the resulting high rates of return on equity can power stock market returns higher. This response helped to fuel strongly positive stock market returns in the 1980s that lifted the total return on major indexes well above the ravages of inflation.

This Blog Post is provided by BerganKDV Wealth Management, LLC for informational purposes only. Investing involves risk, including the potential loss of principal. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail going forward. There can be no assurance that any investment or strategy will prove profitable or avoid losses. No portion of this commentary is a solicitation to buy or sell a security. The content should not be viewed as personalized investment advice. Information presented is believed to be factual and up-to-date but we do not guarantee its accuracy or completeness. All expressions of opinion are subject to change without notice. BerganKDV Wealth Management, LLC. is registered as an SEC Registered Investment Adviser. Copyright (c) 2016

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