The economy is hot. So hot, in fact, that it overheats.
The unemployment rate fell to 3.6%. Consumers have saved an additional $2.5 trillion in additional savings now compared to pre-pandemic times. Earnings are up.
So what is the problem?
These indicators are retrospective. They do not take into account the current rate of inflation, which has been high for 40 years. The consumer price index rose 8.5% in March from a year ago, hitting a level not seen since the late 1970s. Meanwhile, car and gasoline prices increased by 40%.
To curb our rampant optimism – and the accompanying inflation – the Federal Reserve has announced that it will raise interest rates significantly before the end of 2022.
With the right planning, your portfolio can hold its own despite drastically changing conditions coming from the Federal Reserve.
So what can you do to protect your portfolio from the actions the Fed will take to reduce inflation?
- Avoid debt-hheavy companies. Businesses that have large loans will have bigger bills to pay as rates rise, making it harder for them to balance their budgets. Instead, look for companies with little debt that can sustain profits with little investment. Tech companies can fit this mold, especially if they have other features on this list.
- Look for companies with pricing power. Companies that have a strong market position and few competitors can raise their prices as needed. An example is an MLP (Master Limited Partnership) pipeline, which essentially transports oil from the well to distribution centers. Avoid utilities and railroads which tend to be indebted and heavily regulated.
- Immovable. Mortgage rates have reached their lowest level, but remain near historic lows. If you buy now and get a fixed rate mortgage, your monthly payments will stay at that level. For a $300,000 loan, each 1% increase means an additional payment of $200 per month or $2,400 more per year. Real estate investment trusts (REITs) are also worth a closer look. Rising rents help fight rising rates. REITs have diversified into areas such as data centers and cell towers, beyond the former retail and office sectors that make up a lower slice of the market.
- Obligations. Thanks to their low correlation and low volatility, bonds have a place in many portfolios. Think of the coming months as two cycles: bonds should have a shorter duration in the first cycle of rising rates and inflation. If a recession starts to hit because of repeated rate hikes, the Federal Reserve will pause and may even lower rates. Look for longer dated bonds in this second cycle.
- Invest in the asset classes of value stocks and international stocks. Leaning, not overinvesting, in these areas during high inflation can be a good idea. A recent study by Equitas showed that these asset classes perform better in times of high inflation, possibly because both categories start at lower price-earnings ratios than the S&P 500. The story is not not a guarantee, but during periods of rising interest rates we tend to see price and earnings ratios flatten out.
In short, during a period of higher interest rates and inflation, it is better to own productive assets and avoid higher duration bonds (10 to 30 years) which do not increase payments when inflation increases.
Either way, investors shouldn’t panic when interest rates rise and the Federal Reserve steps in to enact changes aimed at slowing the economy. Because what Charles Dow said in 1900 remains true – “the fact of all conditions is that they will change”.
Just make sure your portfolio is prepared not only to withstand Federal Reserve changes, but also to anticipate them and incorporate them into your investment strategy.
Derek Fossier is President of Equitas Capital Advisors LLC, a New Orleans-based company that designs, builds and delivers financial solutions to investors.