The bright side of higher interest rates

High interest rates have gotten a bad rap lately, and understandably so.

The Federal Reserve raised rates from a range of 0.25%-0.50% in March 2022 to 5.25%-5.50% in October 2023 to put an end to decades-high levels of inflation. Their rapid ascent sparked one of the deepest stock-and-bond-market defeats on record, inflicting heavy losses on many investors’ portfolios.

Today, the Fed’s higher rates are also to blame for higher borrowing costs on home mortgages, credit cards and student loans, putting pressure on households. What’s more, even as the U.S. economy has exhibited stronger growth than expected, if rates stay too high for too long, investors fear that may tip the economy into a recession.

Over the longer term, however, higher rates aren’t all that bad, and not just because they help to fight inflation in a growing economy. It may not be obvious, but higher rates also help to:

• Steer resources to growing enterprises. “Free money”—as in, money that comes with very low interest, akin to what was available for more than a decade after the global financial crisis in 2008—can create inefficiencies, such as when unprofitable companies with no prospect for sustainability hang on thanks to infusions of cash. Higher rates tend to lead to a more efficient allocation of capital across the economy, steering resources to growing enterprises that can put it to more productive use.
• Provide more income to savers, retirees in particular, who rely on fixed income. When rates are high, banks typically increase the interest they pay on deposits, bond coupons go up and entitlement payments such as Social Security tend to rise.
• Open new investing opportunities. For many years, ultra-low rates helped boost the stock prices of fast-growing companies by making their future earnings look more attractive in widely used pricing models. Relatively meager bond coupons, meanwhile, also supported investors’ belief that there was no alternative. However, higher rates change the equation and can present opportunities for:
  • strategic fixed income investing and
  • active management with a focus on value and quality.

As economic growth continues, it’s feasible that higher rates could sustain over the long term. In such an environment, investors should be thinking about balancing their portfolios between offense and defense, with a focus on quality, and engaging in active management.

• In equities, Morgan Stanley’s Global Investment Committee believes the current valuations of major stock indices remain high. With a small number of richly valued mega-cap stocks now dominating these indices, “concentration risk”— or the potential for a portfolio to lose value if one or more of these stocks declines—also remains high. Now may be a good time to look beyond passive index exposure and take a more selective approach to stocks, looking for companies that have quality cash flow, competitive advantages and achievable earnings goals. Opportunities may lie in:
  • defensive and value-oriented sectors such as utilities and consumer staples, as well as in
  • international equities.
• In fixed income, investors can lock in some of the highest coupon rates in years, including in low-risk assets such as U.S. Treasuries. With yields around 5%¹, investment-grade corporate bonds may also offer an attractive source of income. Even if rates were to fall in the near term, the decline would likely mean that bondholders’ investments would grow in value, since the price of bonds rises as rates drop. That’s particularly true for fixed-income assets with longer durations.

Some investors may be hoping for a return to the low rates and cheap money that prevailed before the pandemic. But keep in mind that the investing environment was different then. Economic growth was lackluster, inflation was low, and so was productivity. Those conditions are likely to change over the next several years, in light of the digitization of businesses, a shifting makeup of the labor market, deglobalization and new geopolitical dynamics. This means interest rates are likely to stay elevated for a while. But contrary to what many people might think, that is not necessarily a bad thing and could create investment opportunities for the patient and selective investor.

Source: The source of this article, The Bright Side of Higher Rates, published on November 27, 2023.

¹Morgan Stanley, Fixed Income Insights, 3/5/24