| |
The effect interest rates have on the performance of our economy
cannot be overstated. Understanding how interest rates affect the
business cycle will help you know how to structure your portfolio to
achieve growth while minimizing risk. Read on to learn more.
Would you wear a winter parka on a Florida beach in the middle of
summer? Of course not. I doubt any of us would wear a bikini to go
ice fishing in the middle of a Minnesota winter? I know I wouldn’t!
Clothes are a tool that is used to help regulate our body
temperature. They protect us from the cold or keep us from
over-heating. Their proper use determines our comfort from one
season to the next. We don’t want our body temperature to wildly
fluctuate up and down.
It’s the same when it comes to investing. Unfortunately, many don’t
understand the changing of economic seasons and therefore fail to
adjust the clothing used in their portfolio. As many saw in
1997-2000 and 2000-2002, the investment clothes that work in one
season are close to useless in another.
There are economic business cycles. There are seasons when the
economy is expanding, other’s when it is contracting. There are also
times (called peaks and troughs) that are like spring and fall—times
of transition from one major cycle to the other.
Interest rates are one key in determining where we are in that
cycle. The Federal Reserve uses the rate it charges on over night
loans to banks (the Fed Funds rate) as an accelerator or brake on
the economy.
It may seem strange that small changes in the over night rate banks
pay could have an impact on the overall economy. Banks lend more
money then they receive in deposits. That ‘extra’ money comes from
inter-bank loans and is referred to as the Fed Funds Market. It
stands to reason that if a bank pays more on what it borrows, it
will have to earn more on what it lends.
The Federal Reserve controls the Fed Funds rate by putting money
into the inter-bank loan market or by taking it out. Just as supply
and demand causes the price of a stock to go up or down, so is with
the interest rate charged in the Fed Funds market. By putting money
in or taking money out the Federal Reserve is able to artificially
control the supply demand balance.
Interest rates affect every area of our economy. If you have to pay
a higher interest rate on a mortgage your monthly payment is going
to be higher. Since you can only afford to spend so much a month on
that payment, the interest rate affects the how much home you can
afford.
Likewise, most businesses borrow money to fund expansion, cover
inventory and to smooth out cash-flow. Just like the homeowner, they
have a limited amount they can afford in payments each month. The
amount they borrow affects whether they can build bigger plants, buy
more computers or hire additional employees.
Different industries do well in different parts of the economic
cycle. The construction industry will perform best during periods of
low interest rates because low interest rates are designed to spur
growth. When people and businesses can borrow at low rates they will
build new homes, skyscrapers and factories.
Similarly, we each tend to buy the same amount of toothpaste and
toilet paper regardless of where interest rates are. The companies
that make those essentials aren’t going to see the big change in
demand for their product that a construction company might.
Equity investments can be categorized as cyclical or non-cyclical
based on how they are affected by changes in the economic cycle. The
proportion of each in a portfolio will greatly affect the overall
volatility. I recommend having a portfolio of high-quality
non-cyclical companies. You can then introduce cyclical companies as
the seasons change to add additional growth. Make sure you adjust
the cyclicals as the seasons change.
Economic cycles don’t just affect stocks. They determine whether it
is a good time to own bonds, and what type of bonds to own, as well.
The last several years, interest rates have been at historic lows.
You don’t want to lock in low rates for 30 years. When interest
rates are above the historic norms, that’s when you want to stretch
out your maturities.
Think of your investment portfolio as a living, breathing entity.
Recognize that the investments used in it will determine your
comfort level as the economic seasons change. Doing so properly will
allow you to increase your return while reducing your risk. Take
advantage of economic cycles. Don’t let them take advantage of you.
Have a financial question? Send me an email and I’ll personally
respond, free of charge. Go to www.guardingyourwealth.com and click
on ‘Ask Jeff’.
In addition to being a nationally syndicated columnist and Certified
Financial Planning Practitioner, Mr. Voudrie provides personal,
private money management services to clients nationwide. |
|
