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How Rising Interest Rates Impact the Economy and Your Portfolio

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Infographic showing the historical federal funds target rate, projections for the target rate, and why high inflation has led to an interest rate increase. The graphic also shows how rising interest rates affect various investments using annualized returns during the last two rate hike periods.

Line chart showing how inflation has been above the Federal Reserve target in recent months. Rising interest rates can help combat high inflation.

This infographic is available as a poster.

How Rising Interest Rates Impact the Economy and Your Portfolio

The U.S. Federal Reserve has raised rates for the first time in more than three years. From a rock bottom rate set at the onset of COVID-19, the target rate now sits at 0.25-0.50%. This target range is set by the U.S. Federal Reserve to influence the rate U.S. banks use when lending funds to each other overnight.

On top of the recent increase, the Federal Reserve is predicting that the rate will rise substantially over the next few years. For instance, the midpoint of the target range could be as high as 3.6% by 2023. This infographic from New York Life Investments explores how rising interest rates impact the economy and your portfolio.

Interest Rates and the Economy

Why has the target interest rate risen? It’s all related to the goals of America’s central bank.

The Federal Reserve has a twofold mandate: reach maximum employment and maximize price stability. The inflation rate is key to achieving this mandate.

  • If inflation is too low, people may put off spending because they expect prices to fall, consequently weakening the economy.
  • If inflation is too high or volatile, it’s hard for people to plan out their spending and for businesses to set prices.
  • Moderate inflation can help people make informed decisions about saving, borrowing, and investing.

The Federal Reserve targets a 2% inflation rate, as measured by the Personal Consumption Expenditure (PCE) Index, over the long term.

Inflation Is Spiking

In recent months, U.S. inflation has far exceeded the Federal Reserve’s target. For instance, the 12-month PCE rate was 6.1% in January 2022.

In order to bring inflation closer to the 2% target over the long run, the Federal Reserve has raised interest rates. This has historically caused a domino effect that leads to lower inflation.

  1. Federal funds target rate rises
  2. Banks charge households and businesses higher rates on loans
  3. Households and businesses cut back spending and increase savings
  4. Demand for goods and services falls
  5. Companies raise prices more slowly, or lower prices
  6. Inflation drops

Against this backdrop of rising interest rates, how can investors best position their portfolio?

Fixed Income Investments During Rising Interest Rates

The potential for losses with a change in interest rates—known as interest rate risk—affects fixed-income investments most directly.

For example, let’s pretend you bought a zero-coupon bond with a 1-year maturity.

Purchase price$1,000
Interest rate10%
Payment at maturity$1,100
Bond value$1,000

The day after you purchase this bond, the Federal Reserve raises interest rates. Similar bonds in the market now offer $1,110 in one year, equivalent to an 11% interest rate.

A typical investor would not purchase your bond for $1,000 yielding 10% when they can purchase a new bond for the same price that yields 11%. Your bond’s value must drop so that it also offers an 11% return.

Purchase price$1,000
Interest rate11%
Payment at maturity$1,100
Bond value$991

Note: bond value calculated as $1,100 / 1.11 = $991.

The bond has decreased in value by $9 or 0.9%. In this way, rising interest rates can negatively impact the price of existing bonds.

Historical Returns When Rates Rise

Of course, bonds are not the only investments affected by rising interest rates. The table below highlights annualized returns of various asset classes during the last two rate hike periods. They are grouped within the broader categories of fixed income, stocks, and alternative investments.

Asset ClassJun. 2004–
Jul. 2006
Dec. 2015–
Jan. 2019
Average
Bank Loans5.9%5.2%5.5%
Short-Term Bonds2.9%1.1%2.0%
Long-Term Bonds5.6%2.7%4.1%
High-Yield Bonds8.4%7.5%7.9%
Municipal Bonds4.9%2.7%3.8%
Large-Cap Stocks8.1%10.9%9.5%
Large-Cap Value Stocks12.6%9.1%10.8%
Large-Cap Growth Stocks3.8%12.3%8.1%
Ex-U.S. Developed Country Stocks21.5%5.5%13.5%
REITs24.4%8.4%16.4%
Gold24.5%7.2%15.9%
Global Commodities14.3%0.3%7.3%

Time periods measured from the first Federal Reserve rate hike until one month after the last rate hike, which, on average, is when the effective federal funds rate has tended to stabilize. See graphic for specific indexes used.

In light of this historical performance, there are a few things investors can consider.

Fixed Income
Long-term bonds outperformed short-term bonds during the last two rate hike periods, but had a higher level of risk. Taking risk into consideration, investors may want to diversify their portfolios with a variety of bond durations and maturity lengths.

Stocks
Growth stocks have outperformed value stocks over the last decade, but this trend doesn’t always hold true during periods of rising interest rates. Investing in U.S. large cap equities overall, which includes both growth and value stocks, has historically had the least risk.

Alternatives
Global commodities had the highest average return, but also had the highest risk. Investors may consider holding a portion of their portfolio in commodities if they have a high risk tolerance.

Weathering Rising Interest Rates

Interest rate hikes have occurred throughout history when the Federal Reserve is aiming to combat inflation.

Diversifying across asset classes, styles, and bond term lengths may increase return potential while helping to manage risk.

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Infographics

Europe’s Energy Crisis and the Global Economy

Europe’s energy crisis could last well into 2023. Here’s how the energy shock is causing ripple effects across the broader economy.

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Europe’s Energy Crisis and the Global Economy

Volatile energy prices are squeezing household costs and business productivity in Europe.

While energy prices have fallen in recent months, several factors could influence price volatility looking ahead:

  • Russia slashing energy supplies
  • Rising winter heating demand
  • Shrinking European storage facilities

In the above infographic from New York Life Investments, we show the potential impacts of Europe’s energy crisis on consumers, businesses, and the wider global economy.

1. Impact on Consumers

Energy plays a central role in overall inflation. Here’s how it factors into the consumption baskets of various countries:

CountryEnergy %
of Inflation
Total Inflation Rate
(Sep 2022)
EnergyFoodAll Items Less Food
and Energy
Germany46%9.9%4.5%1.8%3.6%
Italy42%8.7%3.7%2.2%2.8%
Japan42%3.0%1.3%1.0%0.8%
France29%5.6%1.6%1.6%2.4%
United Kingdom28%8.8%2.5%1.3%5.0%
U.S.17%8.2%1.4%1.0%5.8%
Canada15%6.8%1.0%1.3%4.5%

Source: OECD (Oct 2022). Annual inflation is measured by the Consumer Price Index.

As the above table shows, energy makes up nearly half of consumer price inflation in Germany. In the U.S., it contributes to about one-fifth of overall inflation.

Amid energy supply disruptions, U.S. winter heating costs are projected to rise to the highest level in a decade. As heating costs rise, it could impact consumer spending on discretionary items across the economy, along with other essential household bills.

2. Impact on Business

Natural gas and petroleum are key components in many industries’ energy consumption. As a result, the recent rise in energy prices is adding significant cost pressures to operations.

Below, we show how four primary sectors use energy, by source:

U.S. SectorPetroleumNatural GasRenewablesCoalElectricity
Transportation90%4%5%0%<1%
Industrial34%40%9%4%13%
Residential8%42%7%0%43%
Commerical10%37%3%<1%50%

Source: EIA (Apr 2022). Figures represent end-use sector energy consumption in 2021.

In Europe, soaring energy prices have led to production declines in energy-sensitive industries over recent months. As a ripple effect, European fertilizer production capacity has decreased as much as 70%, crude steel capacity has fallen 10%, and aluminum and zinc production capacity has sunk 50%.

In response, some companies may move production out of Europe to regions with lower energy prices. This occurred in 2010-2014 amid high European energy prices, where companies relocated to the U.S., the Middle East, and North Africa.

3. Impact on the Economy

While the energy crisis is having devastating effects on many countries, some markets like the U.S. are more sheltered from the impact. As seen in the table below, the U.S. produces virtually all of its natural gas. Figures are shown in trillion cubic feet.

YearU.S. Natural Gas
Production
U.S. Natural Gas
Consumption
Net Imports
20213531-4
20203331-3
20193431-2
20183130-1
201727270
201627271
201527271
201426271
201324261
201224262
201123242
201021243

Source: EIA (Sep 2022).

By contrast, Europe imports 80% of its natural gas, primarily from Russia, North Africa, and Norway. Not only that, natural gas imports have increased over the last decade, up from 65% of total supplies in 2010.

Meanwhile, the energy sector is seeing strong returns supported by higher oil and natural gas prices, along with key fuel shortages as Russia constricts supplies to Europe. In November the S&P 500 Energy Index was up 65% year-to-date compared to the broader index, with -17% returns.

Europe’s Energy Crisis: Looking Ahead

Given the complex geopolitical environment, Europe’s energy crisis could last well into 2023, driven by many factors:

  • Rising demand from China post-COVID-19 lockdowns
  • Lower European fuel reserves
  • Inadequate energy infrastructure in the medium-term

The good news is that European government relief has reached €674 billion ($690 billion) to cushion the effect on households and businesses.

However, this has additional challenges as increasing money supply may be an inflationary force.

Amid market volatility, investors can avoid getting caught up in short-term market movements and stay focused on their long-term strategic allocation.

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Infographics

5 Key Questions Investors Have About Inflationary Environments

This infographic explores questions on today’s inflationary environment as the economy faces persistent price pressures.

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Inflationary Environment

This infographic is available as a poster.

5 Key Questions on Inflationary Environments

What does a changing inflationary environment mean for financial markets, and how could this impact investors?

While there are no clear answers, the above infographic from New York Life Investments looks at key questions on inflation and the potential implications looking ahead.

1. What Are the Main Factors Driving Inflation?

Often, investors closely watch core inflation since it doesn’t factor in volatile energy and food prices. In September, core inflation rose 0.6% from the previous month while headline inflation, as represented by the Consumer Price Index, increased 0.4%.

DateCore InflationHeadline Inflation
Sep 20220.6%0.4%
Aug 20220.6%0.1%
Jul 20220.3%0.0%
Jun 20220.7%1.3%
May 20220.6%1.0%
Apr 20220.6%0.3%
Mar 20220.3%1.2%

Source: Bureau of Labor Statistics, 10/13/22.

Earlier in the pandemic, surging second-hand car prices and supply-chain distortions were factors driving up inflation. But as dynamics have shifted, rising services costs, including housing, have played a significant role.

Along with these factors, a strong labor market is adding to price pressures. Nominal wages increased 6.3% annually in September, after hitting almost 7% in August, the highest in 20 years.

For this trend to reverse, unemployment levels may need to rise and interest rates may need to increase to cool an overheating economy.

2. What is the Effect of Fiscal Stimulus on Inflation?

In response to a historic crisis, the U.S. government allocated over $5 trillion in fiscal stimulus. The Federal Reserve released research that suggests that the fiscal stimulus contributed to 2.5 percentage points in excess U.S. inflation.

Specifically, the fiscal stimulus affected supply and demand dynamics, stimulating the consumption of goods. At the same time, the production of goods didn’t increase, which elevated demand pressures and price tensions.

As the short-term implications begin to unfold, the longer-term structural effects of record stimulus remain far from clear.

3. How Do Interest Rates Impact Inflation?

When inflation is running high, the Fed often hikes interest rates to cool an overheating economy.

Consider how in February 1975 there was a 17% difference between core inflation and real interest rates, an instance when the Fed got “behind the curve”. This shows that the real rate is far below the core inflation rate.

Sometimes, this prompts the Fed to raise rates to combat inflation. After several rate hikes, inflation fell to 4% by 1983, bringing the real rate and core inflation closer together. The table below shows when this gap rose to the double-digits between 1974 and early 2022:

DateCore InflationReal RateDifference
Oct 197410.6%-0.5%11.1%
Nov 197411.0%-1.5%12.5%
Dec 197411.3%-2.8%14.1%
Jan 107511.5%-4.4%15.9%
Feb 197511.9%-5.6%17.5%
Mar 197511.3%-5.8%17.1%
Apr 197511.3%-5.8%17.1%
May 197510.3%-5.1%15.4%
Jun 19759.8%-4.3%14.1%
Jul 19759.1%-3.0%12.1%
Jan 198012.0%1.9%10.2%
May 198013.1%-2.2%15.3%
Jun 198013.6%-4.1%17.7%
Jul 198012.4%-3.4%15.8%
Aug 198011.8%-2.2%14.0%
Sep 198012.0%-1.1%13.1%
Oct 198012.2%0.7%11.6%
Dec 20215.5%-5.4%10.9%
Jan 20226.0%-6.0%12.0%

Source: Peterson Institute for International Economics, Federal Reserve Bank of St. Louis, 03/14/22. The real policy interest rate is the Federal Funds Rate minus Core Inflation over 12 months.

In January 2022, this gap reached 12%, hinting towards further interest rate action from the Fed.

Over the last 11 tightening cycles since 1965, six resulted in soft landings and three resulted in hard landings. Whether or not the recent tightening cycle will result in a hard landing, also known as a significant decline in real GDP, remains an open question.

4. How Long Will Inflation Last?

From the vantage point of 2022, the direction of inflation is as complex as it is uncertain. Below, we show where inflation may be headed in the near future based on analysis from the Federal Reserve.

 2022P2023P2024P
PCE Inflation5.4%2.8%2.3%
Federal Funds Rate4.4%4.6%3.9%

Source: Federal Reserve Board, 09/21/22. Reflects median projections for PCE Inflation and the Federal Funds Rate.

By 2024, inflation is expected to fall closer to the 2.0% target amid higher interest rates. What other key factors could influence inflation going forward?

 2023 Projection
U.S. Real GDP Growth1.2%
Interest Rates4.6%
Housing Price Growth-10.0%
Unemployment Rate4.4%

Source: Federal Reserve Board 09/21/22, Morningstar, 08/07/22. Interest rates represented by the Federal Funds Rate. Housing Price Growth represented by median U.S. home prices.

A combination of slowing GDP growth, higher interest rates, decreasing housing prices, and higher unemployment could potentially dampen inflation leading into 2023.

5. What May Lessen the Impact of Inflation On My Portfolio?

During inflationary periods, value stocks have tended to perform well, based on data from Robert Shiller and Kenneth French. In fact, value stocks saw nearly 8% annualized outperformance over growth during the 1970s and over 5% outperformance during the 1980s.

Similarly, tangible assets like commodities and real estate have tended to weather these periods thanks to their ability to increase portfolio diversification and stability across economic cycles. For instance, between 1973 and 2021, commodities have averaged 19.1% during inflationary periods while real estate assets averaged 5.0%.

The Big Canvas

Generally speaking, periods of high inflation over history are quite rare. Since 1947, the average U.S. inflation rate has been 3.4%.

Inflation (1947-2021)Percentage of Time Spent
Below 0%16%
Between 0 and 5%57%
Between 5 and 10%20%
Above 10%7%

Source: CFA Institute, 07/19/21.

Against a changing environment, investors may consider balancing their portfolios with more defensive strategies that have been historically more resistant to inflation.

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