After the Fed initially increased rates last year, they took a long pause and it seems now all arrows are pointing towards another increase. The consensus thinking on the economy in the coming years goes something like this: with Trump in the White House, there will be increased spending on infrastructure projects and tax cuts which will further reduce unemployment, increase wages and put pressure on the Fed’s target inflation figure of 2%. The Fed, knowing that this is coming and now not concerned about being seen to affect a presidential election will ramp up interest rates in an effort to curb the coming inflation.
For the presidential side of this argument, I think this remains to be seen. A Trump presidency will be a big question mark just as his campaign was, there is no reason to believe at this point that he will be any less self contradicting and flip flopping except for a couple of issues like trade. So the spending part is not assured, however with a Republican controlled congress and Trump’s tax plan now looking more similar to Paul Ryan’s, we can at least expect some sort of tax reform. Unemployment also recently fell to 4.6% which seems to be what the Fed considers the lower bound of full employment. Normally under these scenarios, inflation is right around the corner.
What to Avoid
This got me curious as to what are a saver’s options when it comes to trying to invest in an increasing rate environment such as this. First of all, there are a few areas you want to avoid and these are:
- Paying Floating Rate Debt – If you have floating rate debt that you took out during this low interest rate environment, you want to either refinance it with fixed rate debt (in the case of a mortgage) or you want to repay it (in the case of a credit card). Once rates go higher your rates will reset higher and you will end up paying more. The message here is get out while you can.
- Purchasing Utilities and High Yield Debt – Utilities stocks are looked at by some as similar to bonds due to their regular and predictable earnings. However higher rates bring 2 things, leverage is more expensive and the share price may fall as yields on other investment may become more attractive. High yield debt suffers the problem of loss of principal since the yields cannot get any higher, so prices are forced to come down to match the new high yield levels.
- Purchasing Companies that Export – US exporters are going to suffer as interest rates rise and consumption increases. Capital will flow in to take advantage of the US growth and higher rates, this will push up the value of the dollar and make imports cheaper here, that will in turn make US exporters more expensive overseas. Think Boeing (BA) or Caterpillar CAT) in the category of big exporters that may lose.
What to Buy (or Do)
Now to the interesting part. If you are like me, you have been investing in your passive income streams and selling down your equity portfolio to take advantage of the gains since 2009. This has brought up my cash holdings and expected future cash flows. Hopefully you have a good amount of cash ready to invest on hand because now is your time to shine. It can be a bit tricky though on how you deploy this cash. I have a few suggestions below on what you should get into in this type of environment.
- Convert Floating to Fixed Rate Debt – If you haven’t already done so, and you have floating rate debt, as mentioned above you should either pay it down or refinance into a fixed rate. Don’t believe the hype of the media telling you that rates have jumped and now the mortgage market is on hold. Each quarter point higher equates to just $83 more per month on a $400 thousand mortgage. If you can afford a $400 thousand home, hopefully $83 does not break the bank for you. Even if rates rise 1.00% on the same $400 thousand mortgage this equates to $333 per month more. Is it a bump? Yes, but if you wait longer rates could creep up even more and don’t forget that if they fall back down you can always refinance into the lower rate. Let’s not forget also that we have been spoiled recently by 30 year mortgage rates that have been at all time lows for some time now (see below).
- Purchase Floating Rate Debt – This is the debt you want to buy. There are a few floating rate ETF’s out there such as the iShares Floating Rate ETF (FLOT) and a few close end funds such as Nuveen Floating Rate Income Fund (JFR) and The Blackrock Floating Rate Income Fund (FRA). However you want to be careful with these. Each one has it’s own objectives and risks. I would prefer one that holds longer term debt that provides more of a pickup in spread and a higher yield. In that department, the Nuveen Floating Rate fund is offering a current yield of 7.03 but this is not a bond ETF, it invests in adjustable rate loans. Also it is a closed end fund so you want to be aware of any premium or discount to the Net Asset Value (NAV) of the market price to the underlying portfolio.
- Defensive Stocks – I think the market is overvalued at the moment. In the chart below you can see the cyclically adjusted P/E for the last 145 years courtesy of Robert Shiller. I take a long term view of the stock market and the plot here is of the price per average of the previous 10 years earnings of the S&P 500. The all time average cyclically adjusted P/E is 16.72 and the current P/E sits at 27.26. We are going into the 8th year of recovery since the financial crisis and the signs of the next recession within the next few years are growing. I am not totally out of stocks but I am selling off some gains that I have made since the crisis and adding positions to very conservative sectors. One sector that I always add to, when times are good or bad is the consumer staples sector ETF by Vanguard (VDC). Over a period of 40 years this sector has outperformed the other sectors of the S&P 500 and the index as a whole. Individual stocks like Proctor and Gamble (PG) which has a durable portfolio of trusted brands quietly has offered stellar returns for investors over the long term so if you are going towards individual stocks I like names like this as well.
Remain Cautiously Optimistic
Although I do not see a recession around the corner, as always I am keeping a portion of my savings in cash as well. I like to have at least 6 months of living expenses on hand at any time just in case something happens. I recommend this to everyone I know because at the end of the day none of us are guaranteed a job or career and surprises happen. You want to have cash on hand to be able to weather the storm of being laid off or fired until you can find another job to pay the bills.
Also, what I have mentioned in terms of my strategy above has to do with my personal investments. I don’t change my strategy for long term investments tied to particular goals. For example I am not adjusting anything in my retirement accounts or my 401k. I am not going to touch that money for at least another 30 years so why would I worry about swings in the market today for something decades away? Even if the market falls off a cliff the magic of dollar cost averaging will bring my returns back up as the market corrects itself. It is important to remain conscious of these things to avoid knee jerk reactions to market movements.
I also am continuing to contribute to my 529 plan for my son and don’t plan on altering my positions. I still have 16 years to go and New York offers low cost Vanguard index funds for the 529 plans which I love. Given that my parents saved for many years for me to be able to attend the school of my choice gives me a sense of responsibility to pass this gift on to the next generation in my family. I am always thanking my lucky stars for the opportunity to not have to worry about debt in college and for the hard work which got me a scholarship for my master’s degree. Instead of paying down student loans, I use the cash I would have used for that to save for my son’s college.
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