How Rising Interest Rates Impact Asset Allocation

Interest rates across the maturity spectrum are now higher than any time over the last decade, and the implications of this new environment on asset allocation and the broader economy are varied. It’s great news for savers and investors with large cash balances now that they can find money market funds yielding around 5%, but it’s not such great news for borrowers looking to make a purchase with higher short and long-term financing costs.

How long will the higher interest rate regime last?

One approach to answer this question is to try to decipher the Fed’s neutral rate for monetary policy and where it will likely settle for the long run. As shown in the chart below, the Fed’s current projections suggest that the Fed Funds Rate will return to a neutral rate of 2.5% over the next 3 years, implying several rate cuts from the Fed as there is less need to fight inflation.

But market indicators suggest the neutral rate may be higher than the Fed anticipates. One such market indicator is the 5 year/5 year forward Treasury rate, which measures expectations for the 5-year treasury yield 5 years from now and is considered a proxy for the market’s view of the neutral rate. This now suggests that the neutral rate will settle in near 4% on a longer-term basis versus the 2.5% the Fed dot plot is predicting. If the market is correct, there may be a higher-for-longer interest rate environment, and that has implications for investors.

Interest Rates & Implications for Asset Allocation

With respect to asset allocation, a higher interest rate environment changes the relative attractiveness of equities versus bonds. If investors can now earn 5%+ with limited risk in high-quality bonds, they should require an adequate premium for having to stomach the volatility of equity markets. One way to visualize this is by looking at the equity risk premium, taking the earnings yield of the market, the inverse of the market’s P/E ratio of close to 20 times, and subtracting the 10-year treasury yield.  As demonstrated below, the current adjusted earnings yield, or in other words, the premium available in equities is down to just 1.0% over bonds, below the long-term average of 1.9% going back to the 1980s. Equities can perform well in times of a lower risk premium, as they did in the 1990s, but it required a major expansion in valuation that eventually reverted back when the tech bubble deflated.  The risk/reward in bonds has improved relative to equities.

Impact on the Economy

Consider the potential impact of today’s interest rate environment on the economic cycle: it’s not simply that interest rates are higher, but that the shape of the yield curve indicates an overtightening of monetary policy and a tougher economic environment. The yield curve in the chart below is as inverted as it’s been since the high inflationary period of the late 1970s/early 1980s, which is the last time the Fed has really had to tackle an inflation problem. In each case of an inversion between the 2-year and 10-year Treasury since then, a recession followed within two years. Now 17 months into the current yield curve inversion, it feels like the clock is ticking. One indicator to watch is the data on weekly unemployment claims, because a sustained rise in claims would be the first sign of a weakening in the labor market and overall economy.

What does all this mean for MAI clients?  

While recessionary conditions are expected in the next 12 months, they may not be severe enough to cause a significant downturn in equities. We believe investors can earn adequate returns on safe assets, making us more inclined to take a modestly cautious approach while staying within reach of each client’s long-term strategic allocation targets.

Investing successfully for the future requires holding onto a properly diversified portfolio through economic cycles. Keeping focus on long-term goals helps avoid emotional decisions at the wrong time and positions clients to capture returns consistent with their financial objectives.

If you have any questions related to this topic or your portfolio in general, please do not hesitate to reach out to your wealth advisor at any time.

Please send your questions, comments, and feedback to: info@mai.capital. Any statement non-factual in nature constitutes only current opinion of this author which is subject to change without notice. Certain statements are of future expectations and other forward-looking statements are based on management’s current views and assumptions. Any statistics mentioned have been obtained from sources we believe to be reliable, but the accuracy and completeness of the information cannot be guaranteed. Neither the information nor any views expressed should be considered investment, legal or tax advice, or constitute as a recommendation to buy or sell any security, strategy, or product. It should not be assumed that this is a forecast of future events or that any security transactions, holding, or sector discussed where or will be profitable or that the investment recommendations or decisions we make in the future will be profitable. Past performance is not indicative of future results.