May began with the Federal Reserve’s 10th interest rate hike in a little over a year, raising rates a quarter point1 to a target of 5.25%. This latest increase marks the highest interest rates since 2007. Aside from a slight increase in rates to a peak of 2.38% between 2016 and early 2020, interest rates have hovered near zero for the last decade and a half. And while the Fed has indicated with its latest increase that the campaign to raise rates is likely over for now, rates will remain high in order to bring inflation down to 2% from the current 5%. Here’s what you can expect when money isn’t free.
The Fed typically raises interest rates in response to rising inflation2. It does this by limiting the money supply available for risky borrowing by stockpiling more risk-free reserves in the financial system. In practical terms, this intentionally discourages consumer spending and investment by making borrowing more expensive, ultimately slowing economic growth and bringing down inflation.
High inflation and interest rates tend to characterize periods of uncertainty in the economy. All of these factors lead to a decline in consumer spending as people save more of what they earn to better prepare for unknowns that lie ahead. The percentage of income saved after spending and taxes is known as the savings rate3, which tends to increase with rising interest rates. Experts recommend a personal savings rate of 15% to 20%, which is particularly difficult when high inflation makes everything more expensive.
One way in which higher rates discourage investment is by affecting a weaker stock price. When borrowing is more expensive, companies will likely borrow less money, which leads to slower company growth. A stock market investor expecting a 10% annual growth rate will be less inclined to stay invested once that growth projection drops to 6%. Decreased stock market demand reduces stock prices4.
A common alternative to stocks is bonds, but those have their own issues in high-rate environments as well. In historic times of low inflation, fixed-income investments, like bonds, were safe and attractive places to park cash. Because bonds pay a fixed interest rate, they become less attractive as interest rates rise. During these high-rate times, bond prices are low5 because demand is low, making older bonds acquired during low-rate times less valuable.
Because the return on fixed-income investments are unable to keep pace with rising interest rates and inflation, investors may start to look for similarly safe investments with better returns that can compete with a high-rate environment. Dividend paying stocks may be attractive alternatives to fixed-income right now because companies tend to grow their dividends faster than inflation.
We believe the TrueShares Low Volatility Equity Income ETF (DIVZ) may be a good addition to a diversified portfolio during this period of lower stock and bond prices and higher interest rates and inflation. This ETF seeks to offer higher dividend yield than the overall market while still having access to capital appreciation opportunities. DIVZ is concentrated in 25-35 companies across a range of sectors. It seeks to offer above-average dividends and the ability to grow those dividends over time to keep pace with, if not outpace, inflation.