The news cycle for the stock market is in repeat mode. It feels like we’re on an endless rollercoaster ride of rising interest rates, declining futures, and periodic selloffs. We’re guessing at this point that you are tired of seeing it over and over again. Expecting it to change any time soon is unrealistic, but perhaps we can shed some light on why it’s happening.
Why do interest rate hikes disrupt the stock market so much? Most financial analysts called for them months before the Fed Governors made their first move. According to them, raising rates should slow down inflation. Investors knew this was coming, yet many seem to go into panic mode every time it happens. Is selling a rational decision or a knee-jerk reaction?
The relationship between interest rates and stock performance
Grab a cup of coffee. You may need to read this twice. When the Federal Reserve Bank votes to raise interest rates, they’re raising what’s known as the “Federal Funds Rate.” That’s the percentage that banks need to pay when they borrow from other banks. HELOCs are tied to the Federal Funds Rate or LIBOR plus a margin. Traditional mortgages (e.g., 30-year fixed) are primarily driven by the 10-year treasury bond yield.
Lenders will always charge borrowers more than the Federal Funds Rate, so a rate hike means that the business cost of capital goes up. Borrowing money to fund operations or expand becomes prohibitive when loan interest gets into double digits. That’s the idea behind doing it. The economy slows when businesses don’t borrow. In theory, that could slow inflation.
Companies that don’t borrow tend to show lower earnings on their annual reports. Investors look elsewhere when that happens. Many invest in bonds because they view them as a “safer” investment in this economic climate. Others simply sell the non-performing stocks and look to buy companies that are showing higher profits. That’s known as active trading.
The rebound effect of strategic investing
There are two types of active trading. The first is reactive. That’s when investors sell because the market went down. The second is known as strategic trading, which is more of an investment strategy than the first technique. It too involves selling in down markets, but it’s followed up by new investing to improve portfolio performance.
Strategic investing is what creates the rebound effect we generally see shortly after a market sell-off. It’s been more pronounced in recent years because of the increase in retail traders on platforms like Robinhood and Coinbase. They tend to sell quickly during market downtrends, driving prices down. Strategic investors take advantage of that to “buy low.”
What does this have to do with interest rates? Seasoned investors look beyond borrowing rates and futures projections. They analyze balance sheets and evaluate market sectors for signs of a potential resurgence. Passive investors rebalance across all market sectors. Active traders load up on the more promising opportunities. That’s what moves the needle after a selloff.
Are there “recession-proof” investments?
Much of the conversation around rising interest rates centers around a potential recession if the Fed stays on its current course. A recession is defined as two consecutive quarters where GDP contracts. We’re about to close out our third declining quarter in a row. That means we’re already in a recession. The Fed knows that. No one wants to talk about it just yet.
Are there “recession-proof” investments? Stock promoters have been using that term daily since the pandemic. They also like the word “hedge.” Some claim that gold is an inflation hedge. Others promote crypto, particularly Bitcoin, as a recession-proof investment. Neither is true. You also won’t see one sector consistently performing better than others.
Recessions and high interest rates affect every business differently. Companies with a strong balance sheet and lots of cash on hand don’t need to borrow money. Highly leveraged firms will struggle if rates hit double digits. Each market sector has companies with both business models. Look for those that don’t need to raise money to perform better in a recession.
Higher interest rates can balance supply and demand
This is basic economics, but it’s worth mentioning. Part of the reason consumer prices have been rising is that demand is much higher than supply. Under normal circumstances, this could be attributed to manufacturing or materials shortages. In our current situation, supply chain disruptions are reducing onsite inventory. Have you tried to buy a new car lately?
Higher interest rates can slow down consumer demand, particularly on high-ticket items that require financing. That should allow the supply side to catch up. Investors need to ask, “What happens next?” The answer won’t be found on historical performance charts. We’re living in a brand-new world. Strategic investors need to dig deeper to make buying decisions.
A report released by NPR on September 21st suggested that Fed policymakers will increase the Federal Funds rate to 4.4% by the end of 2022. That could push commercial lending rates into double digits. Some banks are already there. We’ll keep an eye on this for you and publish regular updates. 2023 should be an interesting year for the investment community.