Investment Strategies for Rising Rates

PNFP In The News

PNFP In The News

Investment Strategies for Rising Rates

October 06, 2014

Market watchers have been predicting an interest rate hike or so long that it's begun to feel like the fable about the boy who cried wolf. But lest the villagers (played in this rendition by your clients) forget the lesson of that tale, the wolf really did appear, finally, and gobbled up the sheep.

The point being that interest rates will come back, finally, and investors need to be ready.

Of course, the key to constructing a portfolio that can protect against risk and generate attractive returns under a variety of market environments remains simple diversification. But here’s the conundrum: With the U.S. stock market rallying away, despite claims of overvaluation and intermittent correction fears, strategists continue to advise an overweight in equities for all but the most conservative clients. Balancing that stock exposure means also investing in fixed income with as close to zero stock market correlation as possible, aka U.S. Treasuries. But when interest rates do rise—conventional wisdom now says by the middle of next year, possibly sooner—bonds typically take a hit, with Treasuries getting thumped the hardest.

With stocks, it’s less predictable. They can potentially trade off as a result of rising debt costs, although they could perform well, especially certain sectors, because rising rates typically indicates a strong or improving economy.

All of this means advisors need to consider a variety of strategies that can benefit from a rate increase while minimizing any potential volatility along the way. Because putting this barrage of information together and trying to guess exactly when and how it will all play out is no easy feat.

”That’s why I’m not a guesser,” says Brick Sturgeon, a financial advisor with Pinnacle Financial Partners in Nashville, Tenn. “I’ve learned in 25 years in the business that there are very few good guessers. And I think the majority of us do our clients a disservice when we try to market ourselves as good guessers. I tell clients, my job is not to outguess, my job is to keep you from making a big mistake.” (Raymond James is the third-party marketer for Pinnacle.)

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While much of the conversation about rising rates revolves around fixed income, equities generally make up a larger portion of a client’s portfolio and there are issues to consider within the equity portfolio with regards to rising rates.

When the Fed makes its move in an upward direction, it generally means economic indicators point toward a strong or improving economy. And while stocks can lose value when rates jump due to rising debt costs, they typically recover quickly because of strong fundamentals, and they can provide a nice enhancement to returns.

“Everything gets hit when rates rise,” Sturgeon says. “There’s really not a fool-proof method of avoiding rising rates. But equities have the staying power to overcome the damage because rising rates are going to be accompanied with faster growth in the economy. And within, say, six months, the markets will settle down, and equities have the ability to recover.”

There are also certain sectors that tend to do better in a growth economy, those being the cyclical sectors best avoided during a recession or stagnant period. These include sectors related to discretionary consumer spending, as well as technology, industrials, and financials. Indeed, the financial sector makes more money when the yield curve gets steepened.

“If you look at the average, large-cap bank, their balance sheets look great, but low interest rates are squeezing their margins, says Brock Kidd, an advisor with Pinnacle, who works with Sturgeon. “When interest rates go up, their margins should improve.”

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