Be Suspicious Of A Rapid Economic Recovery – Very Suspicious

What’s going on here?

Bonds, stocks, real estate – even gold. All have had one powerful factor to thank for much of their price rises over the past few years: rock-bottom interest rates. Now, however, an economic bounceback could cause rates to rise – with potentially serious results for your portfolio.

What does this mean?

If US stocks aren’t overvalued at their current near-record highs, it’s mainly due to the fact that interest rates, as measured by government bond yields (which move inversely to prices), have themselves been historically low.

True, investors are expecting America’s economy to roar back from coronavirus this year, feeding into higher company profits. But stronger economic growth will likely involve both more borrowing (by businesses, individuals, and the US government) and a rise in the prices of goods and services – a.k.a. inflation. And if interest rates similarly jump, then it could be bad news for your portfolio.

Higher rates increase costs for companies: not only are raw materials, loans, and (maybe) labor more expensive, but future cash flow is worth less today. And while inflation also reduces the value of bonds’ future payouts, less risky investments generally look more attractive – encouraging big institutional investors to cut their allocations to stocks and thereby reducing share prices.

The good news, however, is that not all investments would suffer in such a scenario. Here are a few ways you could soften the blow:

1️⃣ Replace some tech exposure with banking and industrial stocks

Tech stocks are highly sensitive to interest rate rises. Their business models typically trade profitability today for the promise of high earnings tomorrow, and steeper “discounts” to the value of that future cash undermine present valuations (see our Pack on How To Value Stocks for more).

Banks and companies producing construction and manufacturing equipment, meanwhile, should benefit from rising rates. The former will be able to widen the gap between what they charge borrowers and what they pay customers in interest, while the latter will likely do well out of more building activity.

2️⃣ Expand your commodities holdings

Commodities are often regarded as one of the best protections against inflation: as the prices of goods and services increase, so too do the prices of the things used to produce them, particularly as supply often struggles to catch up with demand. Industrial metals such as copper should particularly prosper thanks to their widespread use in infrastructure projects.

3️⃣ Buy the US dollar

If economic growth runs riot, the US Federal Reserve is likely to step in and attempt to keep a lid on inflation by raising its target interest rate for the country’s (and by extension much of the rest of the world’s) economy. All else equal, higher base rates would mean a greater return on US investments, encouraging overseas investors to buy more dollars to invest there.

Given the dollar’s recent weakening and the high number of investors betting on further declines, the US central bank breaking rate ranks with foreign counterparts could lead to a sudden and significant reversal in fortune – rewarding those cunning enough to back the country’s currency beforehand.

Why should I care?

With any unexpected rise in interest rates spelling trouble for your investments, it’s always been important to be aware of the risks. But the really interesting thing is that the question of higher rates no longer looks as academic as it did just a few short weeks ago.

While the Federal Reserve indicated last month that it expected to keep target rates steady until 2023, news of an extra $2 trillion of economic stimulus Stateside could shift things forward dramatically. With much of that money set to be funded by additional national debt, fears of inflation have sent US government bond yields rising recently – reaching their highest level in 10 months.

The US 10-year Treasury yield has been ticking higher (Source: CNBC)

It’s important to note that the above investment ideas would work best in an environment where interest rates are climbing rapidly – and should the coronacrisis’s impact on the economy worsen, rates could sink once again. Nevertheless, the low-interest-rate world on which much of your portfolio’s present value is predicated suddenly seems somewhat less certain…