Is investor concern regarding the first interest rate hike in nine years overblown? A quick study on how stocks perform after interest rate hikes might remove some of your worries.
If you’ve ever heard the phrase, “Don’t fight the Fed,” you can understand the general concern investors have about rising interest rates.
When the Fed is accommodative and rates are low, money is “cheap” because borrowing costs are lower. This helps businesses grow, because it enables loans for new technology and the refinancing of more expensive debt.
In essence, lower interest rates improve the balance sheets of corporations, which then boost profits and thus support higher share prices for the stock of public companies.
Lower interest rates have a similarly positive effect on consumers and the everyday American. Debts, such as high-interest credit cards, can be refinanced into low fixed-rate mortgages, and houses become more affordable with lower monthly payments, even as home values rise modestly. And with businesses growing, jobs are easier to find.
Therefore, when the Fed starts raising rates, it marks the beginning of the end of easy money and investors have good reason to re-evaluate their asset allocation.
But how badly do markets react after one small hike in rates and what will stock prices do over the next few months and over the next year? There’s no definitive answer, but history can provide a few clues.
How Investments Perform Before and After the First Rate Hike
The proper perspective now with regard to rate hikes and market performance is where we are in the business cycle. The first rate hike usually occurs during the mid-phase of the business cycle, when corporate profits are healthy and the economy is growing. It’s a relatively safe assumption to make that we are still in the mid-phase of the business cycle now.
So here are some averages on investment performance before and after the first rate hikes in the past, according to Fidelity:
- Although volatility can be high in the weeks and months surrounding the first rate hike, stocks have averaged double-digit gains in the year after the first Fed move.
- Bonds are slightly negative in the months around the rate hike, but slightly positive one year after and average double-digit gains in the two years after the hike.
- High-yield investments have tended to struggle most around the time of the first interest rate hike but that negativity tends to pass as the late phase of the business cycle approaches.
Of course these are only averages, which means stocks and bonds could do better or worse than these historic numbers suggest. But recent market movements suggest investors may be worrying too much about higher interest rates.
Best and Worst Investment Types for Rising Interest Rates
Keep in mind that higher rates also mean bigger returns for the investors lending their money. And although higher interest rates tend to put a damper on economic activity, that’s usually what the Fed is trying to do when it hikes rates. Rising rates help to curb inflation, which can keep it from getting out of hand and hurting the economy even worse.
Therefore the first rate hike won’t likely be the death of stocks or bonds, especially looking beyond a few months. Here some general rules for investors to keep in mind about investing in the time around the first hike in interest rates:
- The best asset class over the next year will likely be stocks, with bonds and cash coming in second and third for respective gains during the same time frame.
- The best stocks after the first rate hike will probably be growth stocks, with technology as a standout.
- The worst stocks for rising interest rates are likely to be in high dividend-paying industries like energy, utilities and financials.
- As the mid-phase of the business cycle shifts into the late-phase, defensive sectors — such as health, utilities and consumer staples — tend to shift into leadership as growth stocks rotate out of favor.
The bottom line here is that investors, especially those with long-term outlooks, may be worrying too much about the first Fed rate hike in nine years. The timeless investing practices of diversification and dollar-cost averaging will likely prevail as the smartest strategy in the face of rising interest rates.
Kent Thune is a money manager and a freelance writer. His No. 1 holding is his privately held investment advisory firm in Hilton Head Island, SC. Under no circumstances does this information represent a recommendation to buy or sell securities.
