Higher Interest Rates: Headwind, Roadblock – or Opportunity?

Higher Rates Aren’t Always Bad News

Higher interest rates can make some investments worth less — while potentially increasing the income available from certain new investments.

Those two things sound like they shouldn’t happen at the same time. But they can.

Because when interest rates rise, the value of future cash flows generally falls. That can put pressure on the value of some existing assets, while potentially increasing the income available from newly purchased interest-bearing investments.

On Tuesday night, I sat down with Troy and Charles for a discussion on higher interest rates and what they mean for your money. Here’s a link to a replay of the Oak Harvest Livestream on the topic last Tuesday in case you missed it. We tried to cover a lot of topics: stocks, bonds, real estate, commodities, currencies, annuities, and retirement planning. Hopefully we got them all in. But one idea tied almost everything together:

Today, I want to focus on one question:

Are higher rates a threat to your retirement portfolio – or could they also create an opportunity?

First, Know Which Rate We’re Talking About

Here’s something we stressed during our livestream: The Federal Reserve usually does NOT directly control the 10-year Treasury yield. The Fed has a powerful influence over short-term rates.

But longer-term rates are set mainly by the market. And that market is constantly asking two questions:

What will inflation be? And: What return do investors need after inflation?

Think of the 10-year Treasury rate as having two major pieces: real interest rates plus expected inflation.
And knowing which piece is rising can tell us a lot. If real rates rise because economic growth is strong, that can be good for company earnings – but tougher on expensive investments. If inflation expectations rise, commodities and some real assets may benefit. But consumers lose purchasing power, and bonds can struggle.

So don’t just ask: “Are rates rising?” Ask:“WHY are rates rising?”

Follow the Money Through Your Portfolio

Let’s start with the asset that has the clearest relationship with rates:

Bonds. When interest rates rise, the price of an existing bond normally falls. And generally, the longer the bond, the bigger the price move. That’s the bad news. But here’s the good news for retirees:

After that adjustment, new bonds offer higher income. For years, retirees complained that bonds and cash paid almost nothing. Higher rates can change that. You may now be able to earn more income without taking as much stock-market risk. That can affect everything from your bond ladder to your withdrawal plan.

But Stocks Are More Complicated

This was one of the most important parts of our roundtable.

Higher rates generally mean lower P/E ratios. Why? Because a dollar of profit expected ten years from now is worth less today when investors can earn a higher return somewhere else. That is especially important for growth stocks, where much of the expected profit may be years in the future. But there’s a huge catch.

Earnings can beat the interest-rate headwind. We’ve seen this movie before. From 1995 through 1999, the S&P 500 produced five straight years of very strong positive returns. Interest rates moved around and rose sharply during parts of that period. Yet stocks kept climbing. Why?

Two big reasons: Earnings were growing. And productivity was improving. Computers, software, networking and the Internet allow businesses to do more with less. Today, we’re asking a similar question about artificial intelligence.

ChatGPT launched in late 2022. Since then, companies have spent enormous amounts on AI chips, data centers, software and power infrastructure. The big question isn’t simply whether AI stocks have gone up.

It’s this: Will all that AI spending eventually make the overall economy more productive? If AI drives faster productivity and faster earnings growth, stocks may be able to absorb higher interest rates – just as they did during parts of the late 1990s. If earnings disappoint and real rates remain high?  Then high stock valuations become much harder to defend.

And we already saw why earnings mattered earlier this year. FactSet reported that 84% of S&P 500 companies reporting Q1 results beat earnings estimates, while Q1 earnings growth reached 27.7%. 2^nd quarter was even higher but did include some one-time gains.

One Simple Valuation Tool

Here’s a simple calculation we discussed that can help explain this relationship.

Think of it this way.

If a Treasury yields 4%, $100 invested produces about $4 a year. Flip that around, and you’re paying about $25 for every $1 of income.

Now look at a stock. If a company earns $1 per share and the stock trades at $25, investors are also paying 25 times earnings.

But if Treasury yields rise to 6%, an investor may ask, “Why should I pay $25 for $1 of uncertain corporate earnings when I can earn a higher yield from a Treasury?”

That can make investors less willing to pay high valuations for stocks.

But be careful. This is not a stock-market fair-value model. A Treasury bond doesn’t have earnings growth. A company does. Companies can raise prices, improve margins, invent new products and grow profits.

That’s why earnings growth and productivity matter so much. Earnings need to keep delivering.

Now Look Beyond Stocks and Bonds

This same interest-rate story moves through the rest of your portfolio.

Real estate: Higher mortgage rates and higher cap rates can reduce property values. Highly leveraged properties can feel it first. But inflation may also push rents and replacement costs higher.

Commodities and gold: Here, why rates rise becomes especially important. Higher inflation expectations can help commodities. Higher real interest rates can hurt gold because investors have better-paying alternatives and insurance and inventory carrying costs rise.

Currencies: Don’t just look at U.S. rates. Look at U.S. rates compared with other countries. Higher relative U.S. real rates can attract money into the dollar. And then we get to annuities. This is another place where higher rates can actually help retirees.

Insurance companies can invest at higher yields, which can improve the economics behind some newly issued fixed and income annuities. But there’s a tradeoff.

A guaranteed payment may provide income stability, while inflation can slowly reduce what that fixed payment actually buys. So once again: Higher rates create both risks and opportunities.

What Matters to Your Retirement Plan

After our discussion, I came away with three questions retirees should be asking.

First: Income. If bonds and cash now provide better yields, do you need to take as much stock-market risk to fund your retirement?

Second: Asset allocation. If the return available from safer assets has increased, does your old stock-and-bond mix still make sense?

And third – the one I think retirees sometimes overlook: Sequence risk.

If stocks fall 20%, do you have enough cash and short-term bonds that you won’t be forced to sell stocks at the wrong time? That’s where this entire discussion comes together.

Higher rates reduce the present value of many assets you already own. But higher rates also increase the future return available on newly invested money. And that creates what I call the higher-rate paradox.

For retirees, higher rates aren’t automatically good. And they aren’t automatically bad.

The real question is whether your portfolio is built to survive the transition – and then take advantage of the opportunities on the other side.

That’s the part of the interest-rate story that matters most to your retirement.

So if higher interest rates have changed the income available from bonds and cash, changed stock valuations, and changed the tradeoffs inside your retirement plan, this may be a good time to ask whether your plan still fits the environment we’re in today.

If you’re not sure, give Oak Harvest a call. We can take a look at how your investments, income strategy, taxes, and risk management are working together — and help you identify where your plan may need a closer look.

Because the goal isn’t to predict exactly where interest rates go next.

It’s to build a retirement plan that can adapt if they move higher, lower, or somewhere in between.

Call Oak Harvest Financial Group to schedule a retirement plan review.