Investors have been waiting years for interest rates in the U.S. to rise.
In recent years, murmurings by the Federal Reserve, the American central bank, about interest rates have been enough to send markets into a tailspin.
And conventional wisdom says an interest rates rise is bad for stocks – especially “risky” ones like emerging market stocks.
But the truth might surprise you…
Rates aren’t going to go back to a “normal” level anytime soon
For starters, though, I don’t think we’re going to have to worry about rates rising anytime soon. As Tama wrote a few months ago, the chances are slim that interest rates will rise much over the next few years.
Over the past 40 years, the Fed funds rate (which is the weighted average interest rate at which banks lend each other funds held at the Federal Reserve) has averaged 5.3 percent. Over 30 years, the average is 3.65 percent. So the current level (of 1.25 percent) is well below the historic average…
Take a look at the chart below. It shows the market-implied future Fed funds rate from today, to three years in the future. These rates are what the market currently predicts the Fed funds rates will be in the future.
The market is telling you that three years from today, the implied Fed target rate will only be 1.70 percent.
The current upper bound is 1.25 percent. So that means the market is only expecting a further 0.45 percent rate hike from the Fed in the next three years (i.e., from 1.25 percent to 1.70 percent).
Investors think that rates aren’t going to rise much at all over the next three years. But what happens when – at some point – they finally do? Will there be a mass exodus out of stocks and into safer assets?
Here’s how assets perform in a rising rate environment
It’s a common belief that rising interest rates are bad for “riskier” assets like emerging market stocks.
But take a look at the chart below…
This shows the total average return of different assets in a rising interest rate environment from 1994 to 2017. Returns were counted if the 10-year yield rose more than 0.25 percent over a three-month period, and the chart above shows the annualised average returns of each asset class.
And as you can see, “riskier” assets actually outperformed during this time.
High dividend emerging market equities returned an average of 8.6 percent… Emerging market equities returned 8.1 percent… High-dividend Asia Pacific ex Japan equities returned 6.7 percent… and Asia Pacific ex Japan equities returned 6.6 percent. Meanwhile, Asia Pacific equities returned 5.7 percent… and developed market equities returned 4.7 percent.
Meanwhile, “safer” debt assets underperformed. High-yield U.S. equities returned just 2.4 percent… emerging market debt returned just 1.1 percent… and U.S. Treasuries actually lost 3.5 percent of their value.
So in this case, the conventional wisdom has been wrong.
And the truth is, U.S. Treasuries can be just as risky as emerging market stocks
Emerging market stocks are widely thought to be one of the most volatile asset classes you can own. And, conversely, “risk-free” U.S. Treasuries are viewed as the safest asset. But that’s not always the case, because for Treasuries, you have to take interest rate risk into account…
The duration of your bond portfolio is a key determinant of how much risk you’re exposed to.
Duration tells you how long it will take for the interest payments generated to repay the invested principal. Duration will indicate the approximate change in price of a bond for a given change in interest rates.
For example, if a bond’s duration is five years and interest rates rise by one percent, the price of the bond falls by approximately five percent (and vice versa).
The duration of, say, the iShares 7-10 Year Treasury Bond ETF (New York Stock Exchange; ticker: IEF) is around 7.5 years.
And the duration of the Vanguard Extended Duration Treasury ETF (New York Stock Exchange; ticker: EDV) is 24.5.
Those are just two examples. But as a general rule, for every 1 percent move in interest rates, you can expect roughly a 25 percent price move in your ETF. That’s why a portfolio of U.S. Treasuries can be just as risky as emerging market stocks.
So what should you do?
For starters, don’t sell if you think interest rates will eventually rise. The best way to profit during times of low or rising interest rates is to be diversified. And as the graphs above show, interest rates won’t rise materially for a while… and when they do, the assets that conventional wisdom suggests will underperform actually probably won’t do so poorly at all.
Second, if you’re not diversified into emerging markets – you should be. Geographical diversification is important, as we showed here.
So make sure to assess the “home country bias” of your own portfolio. If you have a severe case of home country bias, it would be wise to consider moving some of your money elsewhere. Your portfolio can only benefit from being a little more cosmopolitan.