What ‘Higher for Longer’ Interest Rates May Mean for Your Investment Portfolio

Key Takeaways

• The third quarter was difficult for stocks, especially growth stocks, which had been winners earlier this year. Bonds have gotten clocked, especially longer-term bonds.
• Cash yields, short-term bonds, and energy stocks have benefited from the “higher for longer” sentiment.
• Investors should assemble a portfolio that will stand up reasonably well to a variety of outcomes. That means not sticking your neck out with long-duration bonds but also not just hunkering down in cash.
• It’s a mistake to assume that the worst is over for interest rates and bonds.

Susan Dziubinski: Hi, I’m Susan Dziubinski for Morningstar. The Federal Reserve has signaled that it’s serious about stamping out the latest bout of inflation once and for all. And that has led the market to assume that interest rates will remain higher for longer. What does that mean for investment portfolios? Let’s find out. Joining me today is Christine Benz. She is Morningstar’s director of personal finance and retirement.

Thanks for being here today, Christine.

Christine Benz: Susan, great to see you.

How High Will Interest Rates Go in 2023?

Dziubinski: Not so long ago, many market watchers thought that the Fed would actually begin cutting interest rates, right, at the end of 2023 and heading into 2024, but the Fed has really sounded more hawkish recently. What have the implications for investors been now that this sentiment has really changed?

Benz: Well, bonds have gotten clocked, as you might expect, especially longer-term bonds. Even intermediate-term bonds have had losses recently. If you have some sort of a core bond fund, you’ve probably been seeing a little bit of red ink in your portfolio. We’ve also seen stocks fall back during this period. So, the third quarter was difficult for stocks, especially growth stocks, which had been winners earlier this year. They’ve fallen back quite a bit but are still clinging to positive territory or doing better than clinging. They’re still in positive territory for the year to date.

Which Areas of the Market Benefit From ‘Higher for Longer’ Interest Rates

Dziubinski: Christine, have there been certain areas of the market that actually have done OK during this reversal in sentiment?

Benz: Sure. There have been a few areas. So, investors who hunkered down in cash when they saw yields go up earlier this year or late in 2022, they’ve been doing just fine. Obviously, they’ve been still getting their very generous yields, and they also do not have principal volatility, which seems like a pretty great thing in this environment. Short-term bonds have certainly performed better, held up better than intermediate-term and longer-term bonds. We’ve also seen credit-sensitive bonds do OK during this period. Even though there might be concerns that rising interest rates would hurt some of these overleveraged borrowers, we haven’t seen that yet. The economy continues to be strong and that fuels a sense of optimism that things will be good for these types of companies that maybe aren’t the most creditworthy issuers of bonds. So, they’ve held up relatively well. It’s been the more interest-rate-sensitive, higher-quality bonds, especially long-term bonds that have gotten hit worse.

On the equity side, there haven’t been a lot of winners recently. There’s been sort of this higher-for-longer sentiment prevailing. Energy stocks, though, have been one pocket of good news, I suppose. There’s a little bit of an interplay here because one of the reasons that the Fed is saying that it’s going to keep interest rates higher is that it’s concerned about inflation. Well, energy stocks are one of the main things fanning the flames of ongoing inflation. Energy stocks have performed well, but there’s been a little bit of a negative association with inflation.

Interest-Rate Outlook

Dziubinski: Sure. Christine, if the Fed does keep rates higher for longer, does that mean that the trends that we’re seeing now in the market are likely to persist?

Benz: Well, I think it’s an open question. And this is why I think we’ve seen this sort of sense that the markets are kind of teetering. They’re not sure whether concerns about inflation and interest rates will persist or if we will see some economic weakening down the line. And so, I really like the idea of investors not trying to play economist with respect to managing their portfolios. I mean, there’s no ignoring these trends. They affect the world that we live in. But I’m not sure that they should have a big implication for how you manage your portfolio. I personally really like the idea of staying humble in the face of incoming information and basically saying, there’s a lot we don’t know about how things could play out. And so, I will assemble a portfolio that will stand up reasonably well to a variety of these outcomes that could come down the pike. And so, that means not certainly sticking your neck out with long-duration bonds but also not just hunkering down in cash.

Don’t Assume the Worst Is Over for Interest Rates

Dziubinski: Lastly, Christine, what steps should investors take to make sure that a hawkish Fed doesn’t upset their plans?

Benz: There’s no guarantee that there aren’t more interest-rate hikes down the line. So, I think it’s a mistake to assume that the worst is over for interest rates and for bonds. To the extent that you have fixed-income assets in your portfolio, I like the idea of matching them to your time horizon. If you have a fairly short-term time horizon, you don’t have any business being in intermediate-term bonds, you should be in shorter-term bonds and cash for those near-term spending needs. If you have a time horizon that’s a little bit further out into the future, well, there it is reasonable to hold, say, intermediate-term bonds. If you have equities in your portfolio, I like the idea of having a nice long time horizon for them. I think you should have a 10-year spending horizon in mind, which is not to say that you won’t have an opportunity to spend from your equity portfolio sooner, but worst-case scenario, you won’t have to. Just think about those probabilities of having a positive return over various time horizons and think about your particular spending horizon for your funds.

Dziubinski: So, in general, try to tune it out.

Benz: Absolutely. I think that’s a wise course.

Dziubinski: Well, thanks for your time, Christine. Good to see you.

Benz: Thank you so much, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch “5 Ways to Be a More Tax-Savvy Investor in 2024″ for more from Christine Benz.