How to Invest When Interest Rates Rise

Some assets are likely to hold up better as the Fed raises rates to fight inflation, say experts.

Written by Conrad de Aenlle / May 20, 2022

Quick Bites

  • The U.S. Federal Reserve is expected to continue raising interest rates to fight historically high inflation.
  • As rates increase, the cost to borrow money—for consumers and companies—also increases, possibly hampering spending and growth.
  • If you’re wondering what that means for investments, the good news is there are still opportunities available..
  • Sectors that have been shown in the past to withstand rising rates, like energy and financial services, may fare better than others. Some tech companies are worth considering, too.

There’s an old joke: The pessimist says, “Things can’t get any worse.” The optimist says, “Sure they can!”

That attitude is useful when thinking about the sudden and rapid rise in interest rates now that the Federal Reserve at last has conceded that inflation is a problem that can no longer be dismissed.

Under ordinary circumstances, rising rates worsen the outlook for economic growth and financial market performance because borrowing costs go up. Higher rates mean less money for consumers to spend, which results in lower corporate sales and profits.

When companies have to pay more to borrow money, it means reduced profits today, and less money for them to invest in their businesses, which threatens profits tomorrow, too.

That triple whammy helps explain why the stock market typically fares poorly in a rising-rate environment, as it has this year, but the whammies for stocks don’t stop there.

Higher interest rates mean higher yields on bonds, making them more attractive alternatives to stocks at a time when alternatives are eagerly sought.

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That’s the pessimistic view for stocks, again under ordinary circumstances. But circumstances, in the markets and in monetary policy, have been anything but ordinary since the global financial crisis persuaded central banks to cut interest rates to zero percent, even less in Europe, and leave them there for years.

They also conducted unorthodox experiments in financial engineering, most notably the purchase of trillions of dollars of government bonds and other assets to try to support economic growth and markets.

The extravagantly loose policy has created a contrarian, benign interpretation of the rate backdrop. But, like the optimist’s cheery perspective in the joke, the outcome it portends may be worse ultimately than the conventionally negative one.

The Fed has been expected to hike its federal funds rate to three percent or so, which would be quite a mild adjustment, considering how high inflation is. That has sent a message that while the Fed is promising to get tough on inflation, its heart isn’t really in it.

This widely held belief supported stocks last year and limited losses during much of the first quarter of 2022. Lately, though, not so much.

With inflation remaining stubbornly elevated—consumer prices have been stuck around 40-year highs—Wall Street is coming to believe that three points of rate hikes probably won’t cut it, and that the Fed’s desire to go easy on the markets by going easy on inflation might force it to be more aggressive in the end than if it had taken a firmer approach earlier.

The steep decline in stocks in the last month or so suggests that investors think the Fed will have no option but to keep hiking until the economy has tipped over into recession.

If interest rates are indeed headed higher for longer, how should you change the way you invest? Here are some ideas that financial advisers suggest.

Andy Kapyrin, chief investment officer at RegentAtlantic in Morristown, N.J., pointed out that certain sectors, notably energy, materials, heavy industries and financial services, have long histories of relative strength when rates rise.

Whatever a company does for a living, Kapyrin advises investors to make sure it does it well. In a more forgiving, low-rate environment, financially weak businesses may be able to get by well enough, he said, but as rates rise, the companies that hold up better will have low debt, high profits and strong balance sheets.

In particular, he likes solid, gargantuan technology companies like Amazon, Apple and Microsoft, whose stocks have been hit just like smaller, minimally profitable tech companies whose shortcomings had been overlooked because they had been expected to grow out of them.

“You can’t just have a bright future” when rates are rising, Kapyrin said. “You need a bright present, too. You want companies with positive cash flow.”

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Craig Ferrantino, founder of Craig James Financial Services in Melville, N.Y., also prizes financial strength—“companies with low debt and a lot of cash”—in times of rising rates. They can often be found, he said, in industries that cater to bad habits, such as casino operators and alcohol and tobacco producers.

He also would steer investors toward segments of the economy that enhance others’ productivity, which should be in greater demand as capital expenditure wanes. Semiconductor manufacturing is a good example.

As for conventional value stocks, so called because they trade at cheaper valuations than the broad market, he would be wary, especially if there is a return to 1970s-style stagflation, where inflation increases while economic growth flags. Cheap stocks are cheap for a reason; if they were shunned during more promising economic conditions, a stagflationary environment is unlikely to make them more popular.

When interest rates rise, “the theory is [value stocks] are going to do better, but that doesn’t always work out,” Ferrantino said. “If they didn’t do well in a great economy, how are they going to do well in a bad economy?”

Kapyrin is reserving judgment on how high inflation and interest rates are likely to go.

“It’s too early to tell if three [percentage] points will be enough,” he said. “Once they get there, the Fed will have to take a long, hard look at how the economy and markets are doing.”

Ferrantino has seen enough. As he figures it, the federal funds rate will have to rise to 6.5 percent before this tightening cycle is over.

If he’s right, then owning rate-sensitive investments, such as in energy, sin stocks and the right kind of tech stocks, should mitigate portfolio risk. As for the broad market, returns could be much worse than optimists, and even pessimists, expect, and that’s no joke.

About the Author

Conrad de Aenlle

Conrad de Aenlle

Conrad de Aenlle is a writer and editor with more than 30 years of experience in topics related to financial services and investment, including market performance, portfolio management, economics, retirement issues, estate planning, taxation and insurance.

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