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Craig DeMaio: Interest rates and investing – what to do when the Fed is raising

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craig demaioThe Federal Reserve raised interest rates in mid-June amid indications that two more increases will follow later this year. The rate increases result from confidence that the economy is strong enough to accommodate increased borrowing costs without being stifled. 

The increases, past and future, can fuel higher borrowing costs for virtually any commodity that requires borrowing, from mortgages to credit cards. The most recent rate increase was the second this year and brings the Fed’s benchmark rate to a range of 1.75 to 2 percent. 

So how does this affect us as investors? How should we respond to increased borrowing costs across the board? Is there a way to protect our current investments and improve our financial status during periods of rising rates?

For starters, I recommend reducing long-term bond exposure while providing a solid foundation in short- and medium-term bonds. The latter two investments tend to be less sensitive to rate increases than longer-maturity bonds with rates locked for longer time periods. But we shouldn’t forget that short-term bonds may offer less of a return compared to long-term investment tools. 

Another area where profits may be made from rising interest rates is by investing in stocks of major consumers of raw materials. Raw materials prices typically are stable or even decline when interest rates increase. 

The companies using these materials have an opportunity to expand their profit margin as rates rise, making them a potentially viable hedge against inflation. Rising interest rates also can be good for companies that subsidize home-building or other forms of construction, so it is worthwhile to investigate real estate opportunities. 

In addition to industries that use raw materials, other industry sectors that tend to benefit from rising interest rates — particularly, so-called “cyclical industries” such as financial institutions, industrial companies and energy providers — typically do better in an improving economy. While certain sectors seem to benefit in a rising economy, there are other sectors that may not see substantial growth but are still favorable investments. It is important to keep a balance in your portfolio among sectors favored for short-term and long-term growth and consider the year-over-year increases. If you have questions about how to best manage risk and your financial goals, a financial adviser can talk you through your options.

However, while rising interest rates are intended to keep inflation under control, that same inflation has been eroding wage gains American workers may have recently received due to pay increases and tax breaks. U.S. Labor Department statistics show that average hourly earnings were stable in May as prices of goods and services such as gasoline and clothing increased. 

Despite lower taxes and a tighter labor market, many consumers still aren’t seeing that much more money at the end of the week and that could impact consumer spending. 

One of the underlying factors of consumer spending is psychology. Rising interest rates can affect investors’ psychology. When interest rate hikes are announced, both businesses and consumers tend to try to reduce spending and that could result in lower corporate earnings, so markets drop in anticipation of the reduced profits rather than an actual reduction. 

As with any other form of investing it is incumbent upon the investor to fully research each area under consideration and specifically the types of investments. There is no reason to fear rising interest rates, and in fact, the changing landscape could provide some excellent investment opportunities.

Craig R. DeMaio, a Stamford resident, is a financial adviser with the wealth management division of Morgan Stanley in New York City. He is a co-founding partner of the 1290 Discovery Group at Morgan Stanley. He can be reached at 212-705-4590 or by email at craig.demaio@morganstanley.com.  

The views expressed herein are those of the author and may not necessarily reflect the views of Morgan Stanley Wealth Management, or its affiliates. Morgan Stanley Smith Barney LLC. 

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