In Part 1 of this posting, I talked about how the government’s monetary policy is executed through the Fed to modify interest rates.  To recap: the Fed cannot control interest rates; it can only influence them, and realistically speaking only short-term rates at that.  In order to keep long-term rates low to stimulate the economy after the 2008 crash, the Fed invented quantitative easing (QE), which has left a lot of mortgages on the Fed’s balance sheet yet to be divested.

What impact will the Fed’s interest rate increases together with the unwinding of QE have on our investments?  As always, the answer is complex, and varies across asset classes.  Let’s take a look at the top four major ones: fixed income (bonds), equities (stocks), commodities, and real estate.

• Fixed income: Although short-duration bond funds will likely initially experience some small decline in price, it will be very short-lived.  The bigger (and better) impact will be an increase in their yields.  Money market funds will actually begin to pay interest again, something we haven’t seen since the crash of 2008. In other words, there is little risk in holding such funds right now, although you should not expect big returns from this sub-asset class in 2016.  Longer-duration bond funds are not likely to fare so well, however.  In the short-term, every time the Fed bumps up rates, these funds will take a hit in price.  Over time, the higher interest rates they generate will overshadow the price drops, resulting in better returns.  But if the Fed hikes rates several times this year as predicted, such funds will probably not do well in 2016.  Mortgage-backed securities (MBS), another sub-asset class of fixed income investments, will experience a decline in prepayments as rates increase, resulting in an increase in the duration of the fund’s holdings.  Selecting actively-managed MBS funds that focus on shorter durations would be beneficial.  But the biggest unknown will be the consequence of the Fed divesting the trillions of dollars of MBS securities they had accumulated under QE.  That is uncharted territory.

• Equities: When interest rates increase, it becomes more expensive for companies to borrow funds for operations or for capital improvements.  If these additional costs cannot be passed on to consumers they will negatively impact profits, which are generally the single biggest contributor to stock prices.  Those companies that have strong pricing power within their markets might be able to maintain their profitability, and their stock prices could consequently outperform.  But that’s in the short term.  Once rates stabilize, costs stabilize, and companies across the board become better able to manage their profitability (at least with respect to borrowing).  So in the long run increased rates should not impact the viability of this asset class.

• Commodities: It’s not so much interest rates but the inflation rate that has the biggest effect on oil, industrial metal, and other raw material prices.  When the amount of money in the economy exceeds the investment opportunities, inflation begins to ramp up.  If the Fed fails to rein in inflation through its rate increases, commodity investments could do very well at some point, although there can be a wide variance between the performance of commodity spot (i.e. current) prices vs. futures prices.

• Real estate: In general, real estate does well in higher interest rate environments, if only because of investors’ preference for hard assets during periods when purchasing power declines.  And higher interest rates mean higher lease or rental income for owners of real estate funds.   On the other hand, real estate investment trusts (REITs), which is the way most such funds are structured, have to pay out most of their earnings to their investors.  Those that are not growing (adding new equity) sufficiently have to rely more on debt to finance the purchase of new properties.  Such funds will experience higher costs and potentially lower profitability.  Those funds holding commercial properties (as compared to residential) could fare better if only because lease durations tend to be shorter, allowing faster turnover of lower rate to higher rate leases.

Does this give you a clear idea of how to change your investments under a rising interest rate environment?  Probably not.  There are so many variables affecting investment returns that it’s nearly impossible to get it right following a simple formula.  And as if that weren’t enough, consider this:

• The Fed’s monetary policy mandate was set by Obama. What are the odds that Trump changes it?  And what effect will that have on rates?
• What would the Fed try to do if inflation started ramping up too fast? Or if unemployment started soaring?

In fact, the minutes of the most recent Fed Open Market Committee (FOMC) meeting indicated that members noted “considerable uncertainty” about potential fiscal (government spending) policy changes, and several participants did not expect meaningful fiscal stimulus to start until 2018. Half of the members did not factor fiscal policy assumptions into their projections for future rate hikes.  These are even bigger uncertainties than those affecting the individual asset classes described above.

Since there is no definitive answer for how to invest under specific economic or political scenarios, my advice, as always, remains the same.  It’s OK to tweak your portfolio in the various ways I described above based on your expectations for the future.  But your predominant focus should always remain on your asset class allocations from your investment strategy.  If you get that part right, you won’t have to worry very much about the rest.