What Are the Smartest Investments When the Fed Raises Interest Rates?

What Are the Smartest Investments When the Fed Raises Interest Rates?

Some Investments Better Than Others at Beating Inflation

The U.S. Federal Reserve was late to the inflation party. Since the start of 2022, the Fed has raised its key lending rate at a torrid pace in an attempt to curb decades-high inflation. It hasn’t worked—at least not yet. If anything, the economic data shows that some parts of the U.S. economy are overheated. This means more interest rate hikes are on the table. The uncertainty has been creating volatility in the stock market, leading investors to wonder where they should park their money.

Before we get to that, a little background is in order.

Stocks went on a scorching run in 2021 after the Federal Reserve slashed its key lending rate to near-zero in an effort to avoid a pandemic-related economic meltdown. Low interest rates make it easier for individuals and businesses to borrow money, which, in theory, fuels economic growth.

With rates near zero, the best place for investors to generate income was the stock market. The S&P 500 advanced 26.6% in 2021. Including dividends, it returned 28.4%.

A different story emerged in 2022. Stocks entered that year at record levels and peaked in the opening days. It was all downhill after that. The S&P 500 closed out the year down by 19.4% and the Nasdaq ended the year deep in a bear market, down by 32.4%.

Why the change of fortunes? Low interest rates might help the economy in the short term, but when they’re artificially low for too long, it can lead to an overheated economy.

Federal Reserve Raised Interest Rates 7 Times in 2022

In 2019, before the COVID-19 pandemic, U.S. inflation stood at 1.8%. In 2020, it fell to 1.2%. To cope with COVID-19, the Federal Reserve cut the federal funds rate twice in March 2020, from the range of one percent to 1.25% to the range of zero percent to 0.25%. (Source: “FOMC’s Target Federal Funds Rate or Range, Change (Basis Points) and Level,” Board of Governors of the Federal Reserve System, last accessed March 3, 2023.)

In 2021, U.S. inflation was 4.7%. In June 2022, the country’s inflation peaked at a four-decade high of 9.1%. (Sources: “Inflation Rates in the United States of America,” WorldData.info, last accessed March 3, 2023 and “Here’s the Inflation Breakdown for December 2022 – in One Chart,” CNBC, January 12, 2023.)

Back then, experts said the red-hot inflation was just temporary, but it wasn’t.

To get a handle on that inflation, the Federal Reserve initiated a number of interest rate hikes. In the first quarter of 2022, the Fed held the federal funds rate around zero. But in response to rising inflation, the central bank raised its interest rate seven times that year, from the range of zero percent to 0.25% to the range of 4.25% to 4.5%.

The supersized rate hikes and the hope that inflation would get under control juiced investor optimism at the start of 2023. The S&P 500 advanced 6.2% in January, marking its best opening month in four years. The Nasdaq Composite climbed 10.7%, for its best January since 2001.

Unfortunately, it takes months for monetary policies to work their way through the economy. As a result, inflation is still high and the economic outlook remains uncertain.

Stocks Tumbled in February on Fears of Additional Rate Hikes

In February of this year, the Federal Reserve said inflation was still stubbornly high. The Fed raised its key lending rate by 25 basis points to the range of 4.5% to 4.75%. It also said “ongoing increases” would be needed to get inflation down to two percent. (Source: “Federal Reserve Press Release,” U.S. Federal Reserve, February 1, 2023.)

Investors didn’t like the sound of that. They began selling off stocks in February, and share prices took a sharp downturn on February 21. All three major U.S. stock market indices fell by at least two percent that day, booking their worst daily drop since last December.

It appears as though investors have finally accepted the fact that the Federal Reserve will continue its aggressive rate hikes to tame inflation. Whereas traders had previously believed the Fed would raise its key lending rate by 25 basis points when it meets in March, there’s now a growing consensus that the central bank will raise the rate by 50 basis points. (Source: “Stocks Catch Up With Fed Reality. Why the Market May Have Already Peaked.Barron’s, February 22, 2023.)

Investors had entered 2023 expecting the Federal Reserve to hold its rate hikes steady. It’s increasingly looking like we’re in for higher interest rates for a longer period. That could tip the U.S. economy into a recession.

Analysts with JPMorgan Chase & Co (NYSE:JPM) recently said the stock market could peak for the year in the first quarter, in part due to the fallout from the Fed’s monetary tightening. (Source: “Stock-Market Rally Could Peak Before First Quarter Is Over, say JPMorgan Strategists,” MarketWatch, February 22, 2023.)

Billionaire investor Leon Cooperman said the S&P 500 could fall by about 35% from its peak of 4,800 to 3,120. At its current level, that represents a decline of about 22%. (Source: “We Are Heading Down’: Leon Cooperman Warns That Stocks Could Plunge 22% From Here — He’s Using These 2 Stocks for Protection,” TipRanks, March 1, 2023.)

How Can Investors Protect Themselves as Interest Rates Rise?

Just because stocks are expected to fall doesn’t mean investors should flee the village. Here are some options to make financial gains.

Traders Can Beat Inflation With Blue-Chip Dividend Stocks

Not all stocks took a hit in 2022. Blue-chip, high-yield dividend stocks held up well amid rising interest rates and decades-high inflation. This is a testament to their strong operations and cash-flow generation. For investors with a long-term horizon, be it 10 years, 25 years, or more, dividend aristocrats (S&P 500 companies that have raised their dividends for at least 25 consecutive years) are the best place to start looking.

To be able to raise its dividends for at least a quarter of a century, a business needs to make a ton of money no matter what. Whether there’s a recession, war, pandemic, or another type of black swan event, these companies sell products and/or services that people need. They rake in a lot of money and return a large portion of it to investors in the form of growing dividends and share buybacks.

Not only do dividend aristocrats provide annual pay raises in terms of dividends, but they also tend to provide higher share-price appreciation than the S&P 500 over the long term. As a result, dividend aristocrats are a fabulous way to fight inflation and stock market volatility.

Bank Profits Are Tied to Interest Rates

Rising interest rates aren’t bad for everyone. The banking sector’s profitability is tied to interest rate hikes. Interest rate increases boost banks’ yield on cash, which gets funneled directly into earnings.

Case in point, JPMorgan Chase announced that its fourth-quarter 2022 profits and revenues topped expectations, with its interest income jumping by 48%. (Source: “JPMorgan Tops Estimates for Fourth-Quarter Revenue, but Says Mild Recession Is Now ‘Central Case’,” CNBC, January 13, 2023.)

Bank of America Corp (NYSE:BAC) posted excellent fourth-quarter 2022 results that included its earnings and revenues climbing due to interest rate increases and loan growth. (Source: “Bank of America Tops Expectations as Higher Rates Help Offset Declines in Investment Banking,” CNBC, January 13, 2023.)

Treasury Inflation-Protected Securities Are Made to Beat Inflation

Treasury Inflation-Protected Securities (TIPS) are government bonds that go in step with the rise and fall of inflation. When inflation goes up, interest rates go up, too. When deflation kicks in (which is rare), interest rates fall. The U.S. Treasury Department adjusts the par value of TIPS based on the consumer price index (CPI), which is a core measure of inflation. (Source: “Treasury Inflation-Protected Securities,” Forbes, May 24, 2022.)

TIPS pay interest twice annually at a fixed rate. The bonds are issued with five-year, 10-year, or 30-year maturities. When those bonds mature, investors are paid out at the adjusted principal or original price, whichever is higher.

Like most investments, earnings from TIPS are subject to federal taxes but are exempt from most state and local taxes.

Gold Is a Great Hedge Against Inflation

When it comes to investing, it can be beneficial to have a healthy dose of contrarianism.

At the moment, the stock market is volatile, corporate earnings are lackluster, and the global economy looks like it’s heading toward a recession. That doesn’t mean it’s always going to be this way, and investing is about taking advantage of market conditions.

Gold was an inflation hedge in the 1970s, but then it retreated. Decades later, the precious metal went on a spectacular run after the events of 9/11 and during three rounds of quantitative easing (QE) before retreating again. Gold also rallied significantly during the COVID-19 pandemic. It has also been performing well since November 2022, due to inflationary and recessionary fears.

Gold is an excellent defensive play and a hedge against inflation. Even conservative central banks agree. As of March 2023, central banks around the world held roughly 35.4 million tonnes of gold, which translates to roughly one-fifth of all the gold ever mined. Most of these holdings are found in advanced economies in western Europe and North America. (Source: “Latest World Official Gold Reserves,” Goldhub, last accessed March 3, 2023.)

You can invest in either physical gold or shares of gold mining companies.

Investors Can Beat Inflation With Real Estate

Real estate is another way investors can hedge against inflation.

Keep in mind that there’s more to real estate than houses. Other popular real estate assets include development land, timberland, farmland, office space, apartment buildings, commercial buildings, toll bridges, and airports.

Investing directly in real estate requires a lot of start-up capital, but investing in shares of real estate investment trusts (REITs) is more affordable. REITs are companies that finance or own income-producing real estate in a wide range of property sectors.

There are two main types of REITs: equity and mortgage REITs. Equity REITs generate income from renting out and/or selling properties. Mortgage REITs invest in mortgages instead of real estate. They provide financing for income-generating properties by purchasing or originating mortgages and mortgage-backed securities and earning income from the interest on these investments.

To maintain its status as a REIT, a company must distribute at least 90% of its taxable income as dividends. This typically results in ultra-high-yield dividends.

The Lowdown on Investing When Interest Rates Are Rising

Amid surging inflation, now is the perfect time for investors to review their portfolios, rebalance them, and make sure they align with their long-term goals.

There are many ways in which investors can protect themselves against inflation. Some are safer than others. Investing in TIPS is the safest way, since these bonds are tied to inflation. Moreover, blue-chip dividend stocks tend to outpace the broader market during inflationary periods. Best of all, with a high-yield, blue-chip stock, you get quarterly dividends and annual pay raises.

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