Rising rates may call for a shift in investment strategies

A woman looks at a stock market display board.

A review of all aspects of your investment plan could be in order.

Brian Rehling, Head of Global Fixed Income Strategy, Wells Fargo Investment Institute
Brian Rehling,
Head of Global Fixed Income Strategy,
Wells Fargo Investment Institute

Editor’s note: This column from earlier in the year has been updated to address recent market activity and Federal Reserve (Fed) actions.

Almost every asset, with the exception of commodities, the U.S. dollar, and cash, has experienced negative year-to-date returns.

Sentiment has been falling all year in financial markets. Clearly, these are tough times for investors. While the indicators tell us to expect more difficult days ahead, you don’t have to sit idly by. There are strategies for you to think about in response.

What is the Fed up to?

Much of what’s been going on in the markets has been in response to the Fed’s activities. Having a grasp on why it’s taking these actions can be helpful in understanding what may lie ahead.

At the pandemic’s onset, the Fed made a number of moves, including cutting interest rates to near zero, to help bolster the economy. In large part, those easy-money policies worked; however, there was also an unwelcome result — inflation rose to levels not seen in decades.

To help tame inflation, the Fed has been increasing the federal funds rate, which is one of the primary “levers” it can pull to help raise interest rates. With the latest increase, it stands at 3.00% – 3.25% (at the time of this publication).

The rationale for raising rates to help tame inflation is predicated on this:  Higher interest rates increase consumers’ and businesses’ borrowing costs, which should discourage them from making major purchases, many of which are financed using credit. Delaying these purchases should slow the economy and, eventually, lower the inflation rate.

The Fed is walking a tightrope. On one side, if it increases rates too slowly, inflation could get further out of hand. On the other, if it’s too aggressive, it could drive the economy into a recession, which some argue has already occurred.

What should you do next?

Whether the Fed is doing a good or bad job of walking that tightrope is a discussion for another day. For now, we expect it will continue to raise rates this year and into early 2023. This will likely impact many aspects of an investment plan. Here are five ideas we encourage you to consider now:

Be strategic with cash

If you sold stock in response to market volatility, you may be holding more cash than usual. The good news is that rising rates will likely improve your return on cash. The bad news: It’s unlikely to be enough to keep pace with inflation over the near term.

Assuming the Fed’s moves are effective in reducing inflation, your cash holdings’ returns may still lag it. As a result, your cash is liable to lose purchasing power. That means it will likely buy less a year from now than it would if you spent it today. And the story is even worse if it’s in taxable accounts where taxes will further reduce your returns.

Rather than holding cash, I recommend working with your financial advisor on a plan to put it to work.

Review your bonds

As interest rates increase, existing bonds’ prices tend to decrease. And that could be especially true for any longer-term bonds you may have purchased in recent years, perhaps in search of higher yields.

Should you go to the extreme and sell all your bonds? Before you do, I recommend you consider the total-return (price plus yield) picture. If you neglect yields and consider only price movement, you are missing half the picture. Second, if you hold the proceeds as cash, you’ll face the issue we just talked about. Third, remember why fixed income is included in many asset allocation models: diversification, lower volatility, and liquidity.

Remember stocks

Certainly, the stock market has taken a beating this year, but historically, times like these have proven to be opportunities. We recommend you keep an eye on your portfolio allocation strategy. Think about reallocating to some of our favored sectors. Ask your financial advisor for the latest guidance to consider.

Examine your loans

Rising rates are bound to impact loans as well as investments. The most immediate impact is likely to be larger debt payments on loans tied to short-term or floating-rate debt. If you have these types of loans, analyze your personal balance sheet to determine whether your liability structure is appropriate.

In regard to fixed-rate mortgages, the Fed’s moves will not increase your payments for the life of a loan if you currently have one. However, if you’re in the market for a new home, remember fixed-rate mortgages closely track longer-term interest rates, so you can expect to see rates rise on these loans.

Consider alternative investments

You might be surprised to learn that certain alternative strategies could provide a reliable income stream. If you’re a qualified high-net-worth investor, I suggest consulting your financial advisor about alternative investments or ownership of individual bonds within a well-diversified portfolio in an effort to mitigate interest rate risk.

We’ve been here before

While past performance is no guarantee of future results, our years of experience suggest to us that if economic cycles are normal, with predictable patterns that have recurred over time, then portfolios need to be managed accordingly.

We have stated all year that given current circumstances, we believe investors should be playing defense in both their stock and bond portfolios. Nothing that’s occurred recently has caused us to change that message. In fact, we resolutely stand by it today.

We recommend you talk to your financial advisor to determine whether adjustments such as these, or others, may be necessary and to help ensure your investments are still aligned with your long-term goals.

This column represents Wells Fargo Investment Institute’s opinions as of the date shown and are subject to change at any time.

Wells Fargo Investment Institute, Inc. is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

Investments in fixed-income securities are subject to market, interest rate, credit, and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can cause a bond’s price to fall. Credit risk is the risk that an issuer will default on payments of interest and/or principal. This risk is heightened in lower-rated bonds. If sold prior to maturity, fixed-income securities are subject to market risk. All fixed-income investments may be worth less than their original cost upon redemption or maturity.

Alternative investments, such as hedge funds, funds of hedge funds, managed futures, private capital, real assets and real estate funds, are not appropriate for all investors. They are speculative, highly illiquid, and are designed for long-term investment, and not as trading vehicles. These funds carry specific investor qualifications, which can include high income and net-worth requirements as well as relatively high investment minimums. The high expenses associated with alternative investments must be offset by trading profits and other income which may not be realized. Unlike mutual funds, alternative investments are not subject to some of the regulations designed to protect investors and are not required to provide the same level of disclosure as would be received from a mutual fund. They trade in diverse complex strategies that are affected in different ways and at different times by changing market conditions. Strategies may, at times, be out of market favor for considerable periods with adverse consequences for the fund and the investor. An investment in these funds involve the risks inherent in an investment in securities and can include losses associated with speculative investment practices, including hedging and leveraging through derivatives, such as futures, options, swaps, short selling, investments in non-U.S. securities, “junk” bonds and illiquid investments. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. At times, a fund may be unable to sell certain of its illiquid investments without a substantial drop in price, if at all. Other risks can include those associated with potential lack of diversification, restrictions on transferring interests, no available secondary market, complex tax structures, delays in tax reporting, valuation of securities and pricing. An investment in a fund of funds carries additional risks, including asset-based fees and expenses at the fund level and indirect fees, expenses, and asset-based compensation of investment funds in which these funds invest. An investor should review the private placement memorandum, subscription agreement and other related offering materials for complete information regarding terms, including all applicable fees, as well as the specific risks associated with a fund before investing.