Investors have been waiting years for interest rates in the U.S. to rise.
And we’ve recently started to see some rate hikes in the U.S.
So what does that mean for stocks?
In recent years, murmurings by the Federal Reserve, the American central bank, about interest rates have been enough to send markets into a tailspin.
And conventional wisdom says an interest rate hike is bad for stocks – especially “risky” ones like emerging market stocks.
But the reality might surprise you…
Rates aren’t going back to “normal” anytime soon
After years of near-zero percent interest rates, we’re finally starting to see rate hikes in the U.S.
Since 2015, rates have gradually risen from 0.25 percent to 1.5 percent.
And with the good jobs figures that were just released – indicating unemployment has dropped to 4.1 percent and could drop further as the short-term adrenaline of tax cuts filter through the American economy – rates look on course to rise even further.
The graph below shows the future Fed funds rate increases the market predicts in the years ahead.
In December, the market was expecting the Fed funds rate to rise from 1.5 percent to about 2 percent in 2019. The market expects the Fed funds rate to be 2.58 percent in the long run. (The long run projection by the Fed is 2.75 percent.)
So investors are expecting rates to rise… but they’re still well below the historical average.
Over the past 40 years, the Fed funds rate (which is the weighted average interest rate at which banks lend each other funds held at the Federal Reserve) has averaged 5.3 percent. Over 30 years, the average is 3.65 percent. So the current level (of 1.5 percent) is still well below the historic average.
But what happens when (if?) – at some point – rates finally do reach normal levels? Will there be a mass exodus out of stocks and into safer assets?
Here’s how assets perform in a rising rate environment
It’s a common belief that rising interest rates are bad for “riskier” assets like emerging market stocks.
But take a look at the chart below…
This shows the total average return of different assets in a rising interest rate environment from 1994 to 2017. Returns were counted if the 10-year yield rose more than 0.25 percent over a three-month period, and the chart above shows the annualised average returns of each asset class.
And as you can see, “riskier” assets actually outperformed during this time.
High dividend emerging market equities returned an average of 8.4 percent… Emerging market equities returned 8 percent… High-dividend Asia Pacific ex Japan equities returned 6.6 percent… and Asia Pacific ex Japan equities returned 6.6 percent. Meanwhile, Asia Pacific equities returned 5.7 percent… and developed market equities returned 4.7 percent.
Meanwhile, “safer” debt assets underperformed. High-yield U.S. equities returned just 2.4 percent… emerging market debt returned just 1.1 percent… and U.S. Treasuries lost 3.5 percent of their value.
So in this case, the conventional wisdom has been wrong.
And the truth is, U.S. Treasuries can be just as risky as emerging market stocks
Emerging market stocks are widely thought to be one of the most volatile asset classes you can own. And, conversely, “risk-free” U.S. Treasuries are viewed as the safest asset. But that’s not always the case, because for Treasuries, you have to take interest rate risk into account…
The duration of your bond portfolio is a key determinant of how much risk you’re exposed to.
Duration tells you how long it will take for the interest payments generated to repay the invested principal. Duration will indicate the approximate change in price of a bond for a given change in interest rates.
For example, the duration of, say, the iShares 7-10 Year Treasury Bond ETF (New York Stock Exchange; ticker: IEF) is around 7.5 years.
And the duration of the Vanguard Extended Duration Treasury ETF (New York Stock Exchange; ticker: EDV) is 24.5.
Now, if a bond’s duration is five years and interest rates rise by 1 percent, the price of the bond falls by approximately 5 percent (and vice versa).
As a general rule, for every 1 percent move in interest rates, you can expect roughly a 25 percent price move in your ETF. That’s why a portfolio of U.S. Treasuries can be just as risky as emerging market stocks.
So what should you do?
For starters, don’t automatically sell if you think interest rates will continue to rise. The best way to profit during times of low or rising interest rates is to be diversified. And as the graphs above show, interest rates won’t reach normal levels for a while… and when they do, the assets that conventional wisdom suggests will underperform probably won’t do so poorly at all.
Second, if you’re not diversified into emerging markets – you should be. Geographical diversification is important, as we showed here.
So make sure to assess the “home country bias” of your own portfolio. If you have a severe case of home country bias, it would be wise to consider moving some of your money elsewhere. Your portfolio can only benefit from being a little more cosmopolitan.
