How Will Higher Interest Rates Impact my Portfolio?

For some time now, most market observers (ourselves included) have expected that the Federal Reserve would eventually raise interest rates from their historically low levels.  In our estimation, monetary tightening was less a question of “if” than “when.” After all, an extended period of near-zero interest rates does as much harm as good (just ask any retiree living on a fixed income, or insurance companies and pension funds struggling to meet their projected liabilities).  Moreover, when you consider that the size of the Fed’s balance sheet—a reflection of the quantity of money created—is more than five times its pre-crisis level, it’s clear that at some point, all of this excess liquidity risks triggering higher inflation, an asset bubble, or both.

Although the precise timing is uncertain, recent comments from central bankers indicate that the Fed is likely to begin raising rates later this year.  The impact on your portfolio could be negligible or more significant, depending on the magnitude and pace of rate increases.  Looking at past cycles of monetary tightening offers the best clue as to how different assets in your portfolio may react to higher rates.   

First, let’s take a look at the US fixed income side of your portfolio. We own bonds and bond funds for two main reasons: protecting capital by reducing overall portfolio volatility (primary) and generating income (secondary). The Fed directly sets only very short-term rates at which banks trade balances with each other, usually overnight, on an uncollateralized basis. Rates along the rest of the yield curve (from a few days to 30 years) are influenced by the central bank but ultimately set by the market.

Consequently, longer term rates can move independently depending on the market participants’ outlook on future rates, inflation, and economic growth. In most cases, higher short-term rates lead to higher long-term rates as well. As a reminder, when rates go up, bond prices go down. The more distant the maturity date of the bond, the more sensitive its price to changing interest rates (this measure of sensitivity is called “duration”).

Over the past 12 to 18 months, we have progressively shortened the average duration of our US fixed income allocation. In doing so, our goal is to lessen the price impact of the anticipated Fed tightening. While shorter-duration bonds yield less, we consider the modest sacrifice in yield to be a worthwhile tradeoff given expectations for rising rates (remember that reducing your portfolio’s downside is the primary function of our bond allocation).

Second, what about the impact on stocks? After so many years of a very accommodative monetary policy, the danger could be that the three-fold increase in the US stock market since 2009 has been built on a foundation of easy money. Although pundits debate how expensive the market is, none argue that it is cheap. Historically, tighter monetary conditions have generally led to greater stock price volatility, but not necessarily a bear market. Interestingly, higher stock volatility also typically leads to outperformance from active managers, whereas periods of low volatility favor passive indexing strategies. We do not anticipate making any changes to your equity allocation and fund selection unless your personal situation warrants it.

Third, it is worth noting that some of the assets which fall into the “other” category in our asset allocation model were specifically added for their ability to outperform conventional bonds during periods of rising rates.  Merger arbitrage is an example of an investment strategy whose returns have a high positive correlation to interest rates (i.e. when rates rise, returns from arbitrage strategies tend to increase).

Finally, we should discuss the impact of higher rates on the US dollar. Historically, tighter monetary conditions here at home have led the US dollar to strengthen against foreign currencies. The direct impact on your portfolio is expected to be muted since most of your assets are denominated in US dollars.  While you do own some non-US investments, a portion of this currency exposure is also selectively hedged by some of the international asset managers we’ve selected. Overall, the largest indirect impact of a strong dollar may be increased volatility in emerging market securities, an asset class where we have fairly minimal direct exposure.

To conclude, our preparation for rising rates has mostly involved adjustments to the fixed income allocation in your portfolio. Within the other asset classes, we feel that that our longstanding philosophy of staying away from overvalued assets will serve us well. We do expect increased volatility and, more importantly, much lower returns in the next 3 to 5 years than we’ve had since 2009. To put this in perspective, we would not be surprised if an average balanced portfolio (holding 60% equities and 40% bonds) will barely return anything over inflation, i.e about 2% to 3%.

For investors who are still working, make sure that you’re saving enough to meet your goals. For those already retired, make sure that you keep your expenses under control. Portfolio returns are not likely to provide much of a tailwind in the near term.

“To sail across the ocean, you must balance making progress in fair weather with the ability to withstand the inevitable storms. Those who think only of the storms will never leave the shore. Those who think only of fair weather will never reach the other side.” Shelby M. C. Davis