To fight inflation, central banks decide, in certain conditions, to raise interest rates. Raising interest rates aims to reduce demand and limit the rise in consumer prices.
This means that access to credit becomes more expensive, whether for mortgages, credit card overdrafts or any other type of debt financing. In the case of businesses, their expansion, which also requires borrowing, therefore slows down. So, what does this mean for your investment strategy?
Impact on savings
The first effect to highlight is the clear and direct impact on savings. In this case, borrowers will have to pay more for access to credit, while lenders will be better remunerated. Savings accounts will tend to offer some return and may be an attractive short-term investment if you think you will need the money in the short term.
On the other hand, the returns on short-term savings will often be insufficient to combat inflation, which, it must be noted, is the main reason for rising interest rates.
Bonds become more attractive
As a general rule, rising interest rates tend to push up bond yields. Of course, the effect is not evenly distributed across the bond market, depending on the coupon, the bond's date of maturity and other factors.
A Morningstar study shows that when interest rates were high bond indices were the only ones showing a clear upward trend. This correlation is relatively intuitive: better returns on borrowing lead to better bond performances.
Depending on your risk profile, particularly regarding diversification and stability of returns, it is often worth having some bonds in your portfolio. Indeed it's also often a good idea to increase this allocation if interest rates rise significantly.
Should we neglect equities?
Generally speaking, high-interest rates tend to weigh on equity prices. They squeeze corporate profits and make growth more expensive. However, the impact is not the same for all stocks.
Growth stocks tend to suffer when there is a rise in interest rates. In effect, with a valuation based on future earnings, the present value of future profits is automatically lower. Earnings growth targets are also more challenging to achieve because of the higher cost of debt. Therefore, the prices of these "growth" stocks are likely to fall.
By the same logic, when interest rates rise stocks that promise high, stable dividends immediately compete with higher-yielding bonds.
However, some stocks can benefit from these high-interest rates. In particular, banks and other financial sector shares tend to see their operating margins rise in this kind of situation. As interest rates on loans are higher, their profits increase. Financial stocks, therefore, tend to outperform the market during periods of high-interest rates.
It may also be worthwhile to invest in more defensive stocks the prices of which are not so strongly correlated with economic growth, such as the healthcare sector for example.
Finally, investing in companies with large cash reserves and low debt ratios is also an option in these circumstances. These companies tend to have less need to borrow and are more resilient during a period of high prices.
Remain diversified to face all market outcomes
Increases in interest rates are necessary to prevent the economy from overheating and in order to keep prices at a reasonable level. Unfortunately, it is not impossible that this may lead to a recession. Either way, it remains important to diversify your investments across different asset classes, regions, and sectors to render your portfolio more resilient to sudden movements in the financial markets.
Our experts will be happy to advise you and answer any questions you may have about rising interest rates and the best strategies to adopt in such a situation.