How interest rates can affect your investments

Interest rates are all around us. We deal with them when we buy a car (with help from a car loan) or a house (with help from a mortgage). The interest rate determines how much we might earn on savings accounts or bond funds.

Interest rates also impact the stock market – and therefore anyone who has money invested in it. Here, we’ll take a look at how and why changes in interest rates typically affect stocks, what those changes mean for investors, and what other factors you should be paying attention to as you become an even more engaged investor.

How and why interest rate changes affect stocks

The first quarter of 2020 was rough for the stock market.  With growing concerns related to the global spread of the coronavirus, the Federal Reserve slashed its benchmark interest rate to near zero on Sunday night. And markets reacted almost immediately: the Dow Jones Industrial Average slid by 13% , the S&P 500 dropped 12% , and the Nasdaq Composite lost 12% by the end of trading on Monday.

Prior to this historic action, the Fed had already cut rates three separate times in 2019 in an attempt to boost the economy and offset threats to growth, and once already in 2020 to combat the slowdown caused by the coronavirus. Why connect market movements with interest rates? Traditional wisdom holds that interest rates affect the stock market in the following ways:

  • Higher interest rates mean businesses are less likely to borrow money for growth and expansion, opting instead to fund reduced growth initiatives or forgo growth altogether. Because planned growth is an important component of determining a stock’s value, higher interest rates can cause investors to believe a stock is worth less. Magnifying that effect across markets can lead to widespread losses.
  • Lower interest rates , on the other hand, can mean businesses are more likely to borrow money to fund  growth and expansion initiatives, causing investors to believe those stocks to be more valuable leading to potentially widespread market gains. But what’s really fascinating is that when the Fed announces a change in interest rates, the stock market often reacts immediately, even though it would take months for changed rates to actually affect business performance.

In other words: the stock market’s initial reaction to interest rate announcements is largely anticipatory. Even though the interest rates themselves haven’t had time to affect the actual economy, investors think they know what’s coming and trade in such a way that causes stock prices to either rise or fall.

Generally speaking, this means that – in the short term – changes in interest rates affect the stock market primarily because of investor sentiment.

But it’s important to keep in mind that not every sector is affected in the same way by interest rates.

Interest rate changes: Response by market sector

Most experienced investors expect interest rate changes to affect different market sectors in different ways. For example, when interest rates are decreasing…

Most experienced investors expect interest rate changes to affect different market sectors in different ways. For example, when interest rates are decreasing…

  • Financials (banks, real estate investment trusts, etc.) and Consumer Staples (food, beverages, household items, etc.) are expected to underperform. That’s because financial companies earn revenue from high interest rates (think banks) and consumer staples are considered non-discretionary, meaning people need and use them roughly the same regardless of other economic factors. It’s not like you only buy dinner when you feel richer.
  • Industrials (companies that produce materials related to construction) and Cyclicals (companies that produce discretionary goods and services) tend to outperform. This happens because spending in these sectors is less essential to everyday life. When times are good and money is cheap, people build more and have more discretionary income to spend.

In other words, interest rate changes affect different economic sectors based on how companies in those sectors earn revenue.

So what can you, an engaged investor, do with this information? One strategy is to manage your risk by diversifying your portfolio. This means investing in industries that tend to do well during times of lower and falling interest rates as well as industries that tend to do well during times of higher and rising interest rates. See the table below to get a sense of some of the main drivers of performance for various economic sectors:

As you can see, interest rates are not the only factor driving the market from one day to the next. Each sector has other catalysts and drivers. Think of it like a cocktail menu – each drink has its own mix of ingredients. Adding some ingredients or removing others could make it stronger or weaker.

Diversifying your investment portfolio by including investments from various sectors helps maximize the odds that your portfolio as a whole will continue to grow regardless of cyclical economic forces.

Interesting, right? Let’s go a step further and look at how all this has played out in the real world.

Interest rates in action

The last decade or so offers a fantastic illustration of how interest rates can The last decade or so offers a fantastic illustration of how interest rates can affect the performance of the stock market. Check out the graph below, which shows the Federal Funds Rate from just before the financial crisis of 2007 – 2008 through this month.

The Federal Funds Rate is controlled by the Federal Reserve Open Market Committee (FOMC), which typically adjusts rates in .25-percent increments. While the Fed Funds Rate is not the only interest rate that affects the economy, it’s the one people usually refer to when they discuss an interest rate increase or decrease.

(If you want to dig further into interest rates and the forces that affect them, check out this article.)

See that long trough in the graph where the Fed Funds rate was right around zero (.25 percent)? That was the Fed’s response to the economic crisis of 2007 – 2008. The Fed lowered interest rates to stimulate borrowing and economic investment.

Then, when the US economy began to show steady recovery in 2015, the Fed started gradually increasing the Federal Funds Rate as a measure to prevent inflation. These rate adjustments affected various sectors of the economy in different ways.

To see those effects, check out the following table, which illustrates how various sectors performed yearly from 2008 to 2020.

Take the financials sector for example. In 2008, during a period of lowering interest rates, it was one of the hardest-hit sectors, falling 55% over the year. And this quarter so far, it’s fallen 22%. That’s consistent with the notion that falling rates are a negative for the banking group.

As you can see in the Federal Funds Rate chart above, the Fed left interest rates unchanged for nearly eight years (early 2009 to late 2015). The S&P 500 had gains every year during that period. As the economy improved, leading sectors included consumer cyclicals, technology, industrials, and healthcare. Energy and utility companies clearly lagged.

Overall, it was a good period to buy and hold stocks, as the Federal Reserve’s aggressive rate cuts of 2007 and 2008 helped pave the way for a longer-term bull market.

Fed officials then went on a tightening path. They hiked interest rates on December 19,2018, when the FOMC raised the target range for the Federal Funds rate to 2.25 – 2.50 percent. For the time period that follows, some sectors continued to rise as others fell behind.

 So what’s the takeaway here? Interest rates important, but there are additional factors that investors should look to when evaluating market conditions.

Remember: Earnings trump interest rates

As you can see in the table above comparing key drivers of performance for various sectors, interest rates are just one of many factors that drive sector performance. Oil and gas prices, for example, are the dominant driver of performance for energy companies. And laws, regulations, innovations, the strength of the dollar, and even weather patterns can also impact performance of the companies in that sector. What’s important to remember about all these factors, regardless of sector, is that they are only proxies for the main consideration: company earnings.

The stock market often responds to changes in these factors immediately – before they have a chance to affect the larger economy – because investors are anticipating the eventual impact they’ll have on the performance of companies and sectors. So what’s an engaged investor to do? Pay attention to interest rates, but understand that they’re just one factor influencing company performance.

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