The Impact of Interest Rates on Everything — Part II
Stocks fell further this week as Fed officials clearly signaled a March rate hike and stories of inflation continued to dominate headlines. Investors are recalibrating expectations for a period of slower earnings growth and higher interest rates.
When we first wrote about The Impact of Interest Rates on Everything early last year, we were only a few months into vaccination efforts and stock prices were leaping higher on hopes of recovery. Even then, the bond market was offering early signals that the risk landscape was shifting. Despite supportive rhetoric from the Fed that short-term rates would remain near-zero until 2023, the bond market had already started pushing the widely tracked 10-year interest rate higher to account for the risk of rising inflation and slowing growth.
As we start 2022 with the Fed now signaling three or more rate hikes in the coming twelve months, we can see that bond investors were right, again. The market is faltering, and the near-term could be bumpy. Over the long-term, we retain our conviction that a balanced allocation to both stocks and bonds remains the surest path to sustainable growth.
Short-Term Impact on Bonds
Stock investors can afford to be optimistic because they can theoretically own shares of a company for as long as the company continues operating, waiting out any periods of economic hardship if they believe growth will arrive in the future. Bond investors don’t have that luxury. Bonds must be paid back over a fixed time period, which tends to make the bond market a more realistic and grounded indicator of economic health in the near-term. Right now, it is flashing signs of concern.
Investors have pushed the 10-year Treasury bond yield as high as 1.86% this week, which is a jump of more than 15% from where it started the year just a few weeks ago.1 Whether rates are pushed higher by investor fears or by Fed policy, the impact is fairly direct: as interest rates increase, bond prices decrease. Over the longer-term, these higher interest rates will mean higher yields from newly issued bonds as well as higher rates in CDs and savings. In the near-term, bond funds may be in for a bumpier ride than usual due to price declines in existing holdings with lower rates.
At North Berkeley, we have been shifting client portfolios toward higher quality bonds over the past two years to improve stability — both for client liquidity needs in an uncertain world as well as protecting our ability to rebalance portfolios to take advantage of lower stock prices. When interest rates are rising, we favor shorter-term and higher-quality bonds as they tend to be more resilient and help our clients maintain their purchasing power even amidst inflationary headlines.
Long-Term Potential of Stocks
Higher interest rates make projected future earnings worth less in the present, and historically that has hit technology stocks the hardest. Technology stocks tend to trade at higher valuation multiples, meaning investors are paying extra for the expectation of significant future growth. When that growth becomes worth less, prices fall. With its tilt toward tech, the Nasdaq Composite fell into correction territory earlier this week, with the index down -12% from its Nov. 19 record close.
When the whole market trades at a high valuation, then the whole market becomes interest rate sensitive. That is precisely the issue that could derail gains from here: Investors are already paying a premium for projected growth. The S&P 500 is currently trading at more than 21 times earnings estimates for the next 12 months. That’s above the five-year average of 18.5 and the 10-year average of 16.7.2
The “pull-forward” effect of the pandemic has been worrying investors for months. Covid accelerated all parts of the digital transformation — and now it’s not clear how much growth is left. Recent reports from Netflix and Peloton validate those fears. After adding 37 million subscribers in 2020, Netflix finished 2021 with just 18 million additions. That’s the company’s slowest growth since 2016. Peloton Interactive, the stationary bike maker whose rise-and-fall has been symbolic of the pandemic-era market, plummeted by -24% on Thursday as it announced falling demand and possible shifts to significantly lower production.3
As speculation becomes less economical and the prospective yields on low-risk assets increase of the US dollar increases, another asset class that has come under pressure is cryptocurrency. Prices have been hammered to start the year. Bitcoin is down -21% year-to-date and off almost -45% from the peak; Coinbase is off -24% so far in 2022 and down -48% from its highs.4 Historically low interest rates have impacted every corner of the market over the past decade, and a paradigm shift to a trajectory of rising rates should be expected to have similarly broad impacts — and unwind some of the growth stories that were predicated on near-zero interest rates.
Protecting Purchasing Power
Our clients expect a bit of fluctuation in portfolio values; it comes with the territory of being an investor. Fluctuation, or specifically inflation, in the price of goods and services can be more unsettling — especially for investors who remember periods of disruptive inflation in the 1970s. While we don’t believe current inflation will persist unchecked — there are still strong deflationary forces from demographics and technology — we do believe the interest rates will slowly rise to historically normalized levels. In the near-term, volatility may continue. Over the longer-term, we believe resolutely in the growth potential of a balanced portfolio that includes both bonds and stocks.
A balanced portfolio provides value in both financial and personal terms. When the unexpected arises in your life or inflation drives prices higher in the short-term, a resilient portfolio can be a resource and support your flexibility. When properly designed, balanced portfolios support real people navigating the personal and economic uncertainties of the real world. They provide stability in the present, and protection against the erosion of purchasing power from normal patterns of inflation.
 For historical context, despite relative increases the current 10-yr Treasury rates of approximately 1.8% are still far below the 6% average in the early 1960s.
 Based on Forward P/E; Factset
 Peloton Warns Staff of Layoffs, Changes to Production WSJ
 Dave Rosenberg, Breakfast With Dave, 1.20.2022
Disclaimer: This commentary on this website reflects the personal opinions, viewpoints, and analyses of the North Berkeley Wealth Management (“North Berkeley”) employees providing such comments, and should not be regarded as a description of advisory services provided by North Berkeley or performance returns of any North Berkeley client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data, or any recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. North Berkeley manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.