Rising interest rates and inflation do not mean a return to the 1970s “stagflation” era
If current headlines about rising prices and interest rates are triggering an uncomfortable reminder of the 1970s, you are not alone. To say that period was a challenging time for our economy and the investment markets would be an understatement. Even though there are some comparisons between our current period of rising prices and rates, economists have indicated they see few signs that a repeat of that environment is on the horizon.
One common driver of higher prices in the U.S. economy – both in the 1970s and present day – are geopolitical events triggering supply shortages across a range of energy and other commodity products. However, today’s rising prices also reflect the impact of shortages of labor and materials in some sectors of our economy attributable to the COVID-19 pandemic.
The primary means to put downward pressure on prices to move inflation to a more manageable level is through interest rate increases set by the Federal Reserve Bank. Similar to the steps it took in the 1970s, the “Fed” has steadily been raising borrowing rates for the past year. Fortunately, early results of that program suggest that price inflation as measured by the Consumer Price Index may have peaked. But higher interest rates also apply a “brake” on economic growth as borrowing costs rise for both businesses and consumers. So far, even though growing at a lower rate, the U.S. economy has avoided the two consecutive quarters of negative economic growth that define a recession.
How could higher interest rates and inflation affect an investment program? Even if the Fed’s program of interest rate increases is successful at slowing further inflation, investors nonetheless need to consider how today’s higher price levels and interest rates may affect their investment programs over time.
One potential benefit to investors of a higher interest rate environment is for bonds and bond funds to contribute more meaningfully to portfolio returns. Beginning in 2020, returns on most bond strategies were very modest due to a near zero percent interest rate environment. Even before the Federal Reserve began raising interest rates in early 2022, bond prices – and therefore returns among most bond strategies – began falling during 2021 in anticipation of the Fed’s program. In other words, there has been a “cost” to maintain the important risk control features of bond investments since 2021. If interest rates remain stable or fall from current levels, we expect that the higher interest rates now payable to bondholders will translate to positive returns for most bond strategies.
In the capital growth side of portfolios, the higher inflation and interest rate environment can be a headwind against the stock prices of companies more sensitive to the potential for reduced earnings in a slowing economy. On the other hand, stocks of companies in the more “slow and steady” sectors such as energy, utilities and consumer staples tend to be able to protect profits by “passing through” higher input costs to consumers by raising prices. These companies more typically produce higher levels of positive cash flow, which is attractive to investors in an uncertain economic environment.
Only time will tell what direction inflation and interest rates will take. But we remain confident that being steadfast in a commitment to invest for the long-term and using a diversified mix of strategies will help investors navigate this period with a higher probability of success.
