Higher Interest Rates…So What’s the Problem?Part 2
Last post I spent some time discussing the impact of higher interest rates on portfolio strategy for investors. I thought that it might make sense to discuss possible global effects as opposed to individual portfolios. There are many implications for how a given economy may respond to moves in key interest rates that has various portfolio implications
- Higher interest rates = higher borrowing rates = declining trend in purchasing habits. If you consider there are only two ways to purchase goods–credit or cash. Cash purchases are largely unaffected by interest rates. I mean if you have cash in your pocket to pay for a good you just do it. However, credit purchases (which also tend to be larger purchases) are affected by interest rates. The takeaway is that as interest rates increase, the cost of borrowing also increases which (in theory) should negatively impact credit purchases. This is intuitive since the FED will lower interest rates in economic expansion and raise interest rates in order to slow economy.
Implication in portfolio strategy–> Sectors that involve lending would be favorable. One example of this could be financial services, in that banks can increase the “spread” they pocket by charging higher rates on loans over time.
- Higher interest rates = more foreign investment . If you lived in any country you essentially have two choices for investment–domestic or foreign. In this simplified world, you would prefer to place your invested capital in the investment with the highest possible return (ignoring risk for now). All else being equal, invested capital seeks its highest return. So let’s now include the discussion of risk. Any country’s risk-free rate is basically the rate you would earn on a cash deposit. Given this, we can now establish that you would rather earn a higher return on your cash deposit than a lower one even if you had to deposit your cash into another country’s bank. This is the intuition behind why higher US interest rates will pull capital out of lower interest rate countries into higher interest rate countries for the extra return. Adjusting for the risk of default, according to current central bank rates, the US seems to be one of the best choices for cash investment currently. (Assuming you don’t want to make a cash deposit into Brazil or Russia!)
Implication in portfolio strategy–>Debt obligations of sovereigns with favorable economic outlooks would be favorable. One example could be US bonds (e.g. government, corporate, municipal). Specifically, longer maturities assuming portfolio construction includes bond laddering.
- Higher interest rates = stronger domestic currency. This next notion probably will not be as intuitive given the current state of the global economy, since ultra low interest rates in the US have seen the US dollar as strong as it’s ever been. Theoretically speaking, lower interest rates should weaken a currency given our previous argument because of capital “outflows” to find higher paying currencies (see the following discussion for more detail). Suffice to say, this phenomenon is rare and is due to a myriad of other factors that are not within the scope of this discussion. (Hint: One possible factor is that the US dollar as the reserve currency of the world attracts capital when the fear of global recession exists regardless of the level of interest rates.) So, consider that foreign capital seeking higher returns will buy dollars. This demand for dollars will only increase its value relative to the currency being sold (in order to buy it). Next, consider what happens on the other side of the equation, as capital leaves the foreign country (to buy USD), the foreign currency being sold will weaken. Ultimately the price of goods in that foreign country will fall (relative to the US dollar). This is what you are seeing in copper and other soft metals markets. It is a multi-fold effect in that the country that exports the good receives less of their domestic currency (when they sell) and thus have less to pay back loans, thus deepening the debt cycle.
Implication in portfolio strategy–> Most commodities (e.g. metals, energy) investments, and the weaker emerging markets economies would be unfavorable. For example, metals like copper have experienced multi-year lows as of this writing as demand has weakened and the copper producing nations have accumulated deficits.