Towards the end of last month, the Fed announced it was going to raise interest rates by 0.75% to fight the rising level of inflation. This is the fourth time this has happened this year as the Fed hopes to reduce the overall demand in the economy, which could slow down price growth. Even though adjustments in interest rates normally take at least a year before they have a widespread economic impact, some sectors react more swiftly to the news. One such sector is the stock market, where the response is immediate as markets will try to price future expectations of a rate hike and anticipate the Fed’s actions.
Other than setting the federal funds rate, the institution also determines the discount rate or the interest rate that the Fed charges financial institutions that borrow from it directly. This rate is typically higher than the target federal funds rate to encourage banks to borrow from other banks at the lower federal funds rate. That said, understanding how interest rates impact stock markets can help you as an investor see how the changes might impact your investments. And this helps you make better financial decisions.
Most investors might be aware of the huge impact interest rates have on their debt since the cost of borrowing goes up if they rise. However, some might not be aware that they can impact their investments. This piece seeks to determine the best ways investors can profit from rising rates.
Since the two institutions rely on interest to earn their money, when the rates go up, they get to earn more as credit isn’t easily accessible. This creates an air of desperation where consumers are willing to pay more to be allowed to borrow. Past interest rate hikes by the Fed have seen financial institutions that deal with credit experience an improvement in the interest income and operating profit margins. Interestingly, these financial institutions will still make money even when the rates are low. Borrowers will borrow more and spend extravagantly. The bank will charge less interest but make more due to the larger volume of borrowings.
If a company has large volumes of cash sitting around. When interest rates go up, it earns more on its cash reserves. Any cash-rich company that hoards cash can give you great opportunities to profit during high-interest rate periods. Investors consider companies with low debt-to-equity (D/E) ratios or those with large percentages of book value as cash.
In times of low interest, most investors prefer going for dividend-paying companies as they share part of their profits with shareholders. But, at times of high-interest rates, you need to look elsewhere. Two sectors that have proved to perform better than the rest at such times include those in the tech and healthcare industries. Past studies have shown that these two sectors have recorded average gains that outperform the S&P 500 index during rising interest rates. Companies based on the two sectors tend to retain more profits to invest in growth opportunities rather than pay shareholders dividends.
It’s good to diversify your portfolio, especially in times of uncertainty. This means you should seek new sources of income, especially when the interest rates rise as inflation becomes rampant. As an investor, you can consider the bond market to address the volatility in your portfolio. You can target bonds with short-term maturity dates or go for bonds that have coupon rates that float in concert with the market rate. That said, during rising interest rates, it’s not only fixed-income vehicles that you should consider ideal investments. Come up with a multi-asset approach strategy that will help mitigate the market risks and guarantee a better return on investment (ROI).