Rising Rates Impact Growth
As we’re seeing a move up in rates, it makes sense that investors would shift out of the tech heavy NASDAQ and into more value based companies. But why did it the sell-off occur? It’s all about the cost of capital and the risk-free rate.
Think about it this way, if you’re a new tech company that can borrow at 1%, you’re able to fund lots of new projects to generate future cash flows. In an environment with low interest rates, you can fund R&D, M&A, and other initiatives to further expand your business. Now what happens when a company’s revenue can’t keep up with their debt obligations? Nothing good.
How do Rising Rates Impact a High Growth Company?
Let’s walk through a quick example: I own a car company that makes cars and efficient motors. This company would also like to start developing flying cars! All of these different initiatives must be funded somehow. As a young company, I don’t have a lot of money to pay for everything. At this point I have two options:
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Go to a bank and borrow debt
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Issue more equity
I decide to get a $1M loan at 2% interest. This is a great rate for me because I can easily pay the 2% back with the cash I generate from selling my cars. With a 2% rate, even while paying back the loan, I should still have plenty of money to develop new motors and revolutionize the flying car. This type of financing makes investors optimistic and my company’s valuation grows.
But what happens if the rates go up on that $1M loan and now they sit upwards of 6%? Well I might not have enough capital to properly pay the debt back, which could lead to delays with the flying car and the more efficient motor. This leaves consumers and investors disappointed and now the value of my company has dramatically decreased.
This is a very trivial example, but simple enough to understand how the dynamic works and why we’re seeing all these high-growth tech stocks getting hit so hard.
What Does this Mean for my Portfolio?
In the current environment, the shift away from growth and into value might be a smart transition. Companies with a strong balance sheet and the ability to finance future cash flow opportunities may appear more favorable in the current market. Now is a great time to review your entire portfolio and see if you’d like to gain exposure to other sectors you might have previously been light on.
Remember: What Do Rising Interest Rates Tell Us?
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A rise in interest rates means it costs more to borrow money from the bank.
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Rising rates may spook investors heavily weighted in equities.
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Growth stocks that have not yet become profitable could quickly fall out of favor within the market.
Why are Rates rising?
Economic Growth
With the country reopening and COVID cases declining, many investors are optimistic in regards to future growth. This optimism helps increase rates as borrowers become more willing to bet on the future outlook of America.
Consumer optimism and economic growth could both have huge impacts on the job market. However, it is important to be mindful of the optics of recent reports. For example, if we take a look at recent jobs reports we say a total job creation of 117k. But when taking a closer look into this number, we see that the majority are service providing jobs (+131k) and we actually eliminated production jobs (-14k). When reading job reports, especially as the economy reopens, be mindful of the total count of net new jobs.
Everyone should expect that service jobs will eventually come back. But again, this doesn’t mean net-new jobs, we’re simply getting jobs back that were lost.
Inflation
Inflation, which is becoming a more mainstream concern, is typically measured by using the Consumer Price Index (CPI). CPI is a number that measures the average change in price levels for consumer goods and services. As inflation concerns grow, bond investors expect to get more return for their money because prices will get more expensive. Jerome Powell, chairmen of the Federal Reserve, said last week that we’re not seeing any signs of inflation, but this has been hotly contested.
Why is Inflation Becoming a Concern?
The Fed is stuck between a rock and a hard place, which has resorted in a massive Quantitative Easing (QE) program over the last few years.
Think about it this way: the Fed only has so many options in the toolbox to impact the economy. They can change rates (Fed Funds rate), change regulations (bank reserve requirements), or they can print more money (QE).
The problem we find ourselves in right now is that rates are already so low we can’t go much lower (real rates are essentially negative),reserve requirements are also at the bottom (when the pandemic first started these were cut to zero), and we’ve already expanded the monetary baseline through QE.
How to fight fears of inflation?
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Owning assets or materials
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Look into investing in real estate or other tangible assets
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Think about commodities and emerging markets
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Metals like gold, silver and aluminum are typical hedges against inflation
Portfolio Building in the Current Climate
As we’ve stated, good news in the economy hasn’t necessarily meant new highs in the stock market. With that said, there are many sectors that have performed great during this recent correction.
- Energy Sector +13.5%
- Financials +7.5%
- Basic Materials +4.5 %
- Tech – 6.7%
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| The chart above shows the correlation between the technology leading NASDAQ and the 10 Year Treasury Yield. |
| As you can see, in early February, the NASDAQ was continuing to set new records and there was no discussion or concern over interest rates. Now look at March 8th. Rates were as high as they’d been in a year, and the NASDAQ took a huge loss on that very same day. |
In today’s market, you should consider your gains as a form of purchasing power. Just because you’re portfolio goes up, doesn’t mean your purchasing power increases. This is due to the devaluation of the dollar, thanks to inflation.
Now to be clear, this devaluation doesn’t happen all at once and usually takes a bit to come into fruition. To go back to Economics 101, you may have heard the “shower” analogy. Say, for example, you’re in a cold shower and turn the heat up to make it more comfortable. At first you don’t notice a change in temperature, so you turn it up even more. In the next 5-10 seconds, the shower gets scolding hot because the nob was turned too far- this is how the economy works. If we pump too much money into the system, we can get burned. Remember: inflation is a lagging indicator.
Closing
During times of uncertainty, it’s important to look at how diverse your entire portfolio is. That doesn’t simply mean growth stocks vs value stocks, it also means hedging your portfolio through other assets.
As an investor, it’s important to understand all the different factors that may affect pricing in the market. As interest rates rise, it’s vital to take a holistic approach when assessing the market. Interest rates, economic growth, unemployment and inflation are just a few key factors that can effect stock prices.