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What, Stock Fund Investors Worry About Rising Rates?

Higher rates will affect stock funds, but staying the course is still a good option.

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A lot of investors are worried about rising interest rates and inflation, and not without cause. The yield on the 10-year Treasury bond is at a generational low; government spending and borrowing has erupted; and, although the Fed has said it'll keep its funds rate near zero for "an extended period," that won't last forever. When rates do increase, bond owners will feel it. On that much, most investors agree. There's less consensus on equities. Stocks may be better off than fixed income when interest rates rise, but it's not clear by how much.

No Slam-Dunk
To stay competitive if bond yields rise far enough, the market may reset stock valuations lower to increase their prospective long-term returns. Rising interest expenses also could clip corporate profits. Both of those possibilities spell poor returns for stocks at least in the short term.

How rates rise matters, too, though. High valuations at the start of a rate-tightening cycle can make stocks more sensitive to hikes. Sharp, unexpected spikes in inflation and interest rates, which often coincide, increase the odds of lousy equity returns, but there's still a wide range of possibilities, says Fran Kinniry, an investment strategist with Vanguard. Stocks on average have lost 2.3% when inflation and interest rates rose unexpectedly, according to a Vanguard study. But the range of results is wide, including a period with a 53% gain, Kinniry says. So it's not a slam-dunk that stocks are going to do poorly.

Dan Culloton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.