I do not like to hold cash positions in client accounts as a general rule. These are unusual times, however, as stock valuations are on the high end and the Federal Reserve (the Fed) is set to raise interest rates soon. We’re holding that cash so that should the market take a downward turn, we’ll be able to take advantage and buy at better valuations. This approach takes patience and an understanding that the market won’t necessarily react in the way one expects. Many newer investors may have never faced this situation before, since the last time the Fed raised rates was between 2004 and 2006, as we emerged from the dot-com recession. So, I wanted to go over what raising interest rates may mean for your portfolio.
The specific controllable factor in question is the Federal Funds Rate. This rate is set by the Fed and corresponds to the rate banking institutions pay to borrow funds from Fed banks. It has a ripple effect across all debt instruments. The Fed raises rates to follow its mandate to keep inflation in check. By raising interest rates, the Fed reduces the money supply by making borrowing more expensive. This lessens the problem of too much money chasing too few goods, which often leads to excessive inflation.
After the Fed raises rates, the economic ripples move to the banks as they raise the rates they charge for lending money. This can lead to higher interest expense for leveraged companies, and often reduces investment in growth. The consumer may see increases in mortgage and credit card rates, thereby reducing the income Americans have to spend on discretionary items. Another ripple, given the current global economic situation, is a further strengthening of the U.S. dollar as foreign investors move toward investing in dollar-denominated fixed income instruments in search of higher yields. A strengthening dollar would hurt profitability at multinational corporations with large exposure to European or Japanese markets. Finally, if rates rise enough, money will start moving out of the stock market, to lower-volatility fixed-income investments; this would put downward pressure on share prices. It is this fear that often leads the market to drop when the Fed raises rates (or even when the Fed seems likely to raise rates).
It’s important to remember that stock prices are influenced by many factors, and interest rates are only one piece. As I mentioned above, the last time the Fed raised rates was from 2004 to 2006, and that was a very good time to invest in stocks. If the Fed moves early enough, it will raise rates as the economy expands and, of course, an expanding economy is a very good thing for stocks. If the Fed waits too long, and tries to play catch-up with inflation, the stock market can really suffer. With inflation largely in check right now, I don’t think a rate increase will have a lasting effect on stock prices. But I do expect the market to react negatively in the short-term. Whether that will happen isn’t a sure thing, and there is no way to time the dip perfectly. The important thing is to properly weigh the probabilities and to take advantage of market inefficiencies when you are able. We’ll wait for the Fed to raise rates, which will probably happen in June, and then look to take advantage of some ensuing market turbulence. I’ll keep you updated as events unfold.