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How Rising Interest Rates Will Hurt the Stock Market

Simon Constable

It's all but certain that the Federal Reserve will increase interest rates, perhaps as early as this month and several times in 2018. And that will likely change the dynamics of investing in the stock market.

It may mean that investors should think about changing how much of their portfolio they should allocate to equities, and how much they have invested in bonds.

Short-term rates are moving up. The current Federal Funds rate, which is the Fed's short-term benchmark lending rate, is targeted to be between 1 and 1.25 percent. That's low by historical standards.

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"The Federal Reserve believes that the balance between inflation and growth support a higher interest rate than is currently in place," says Stephen Wood, chief market strategist at Russell Investments in New York.

Typically, higher rates eat into the budgets of individual and corporate borrowers, slowing down spending. That's why the Fed has waited until it believes that the economy is strong enough to withstand the increase in the cost of borrowing money.

The other reason is that rates are still historically low and the Fed is likely feeling increased pressure to move now to give it more flexibility later in the business cycle.

"They want to get while the getting is good," Wood says. The current economic data is benign enough to raise rates now so that they can be lowered aggressively when the economy slips into another recession. It is normal for the Fed to lower interest rates in a recession in order to boost the economy, but rates are so low now there is little room to cut, he says.

Long-term rates are likely moving up. In addition, the interest rates on long-term bonds look set to rise. "In theory, increased growth or increased deficits should put upward pressure on rates," Wood says.

Growth in U.S. consumer spending hit 3.3 percent for the third quarter, according to government data, and the tax reform legislation Trump administration and congressional Republicans are pushing is projected to increase the government deficit by $1 trillion or more.

The upward rise in rates on the U.S. 10-year Treasury note will be mitigated somewhat by international investors seeking better yields for their investments. Rates on German "bunds" and Japanese government bonds are less than half a percent and a tenth of a percent, respectively.

"In the global market, there will be more transnational demand," Wood says. That extra demand will help keep U.S. rates from moving up to very high levels.

What does it mean for stocks? "The central bank's uber-low or even negative interest rate policies have been a major factor in stock performance over the last decade," says David Nelson, chief strategist at Belpointe Asset Management in Greenwich, Connecticut.

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Specifically, the low rates barely meant that returns would keep up with inflation so many investors piled into stocks aggressively so that the spending power of their investments wouldn't get devalued by the withering effects of rising living costs.

The problem is that the equation changes when rates change as they are expected to do.

"Steadily rising rates are not conducive to higher equity prices, and for investors, this could be a rude awakening and an opportunity to rotate into safer havens," says Richard Rosso, director of financial planning at Clarity Financial in Houston. And of course, it isn't just that stocks might not rise, they could fall.

While the bond markets' higher yields are part of the problem, they also offer a solution.

"Rising yields could be a refreshing change and motivate investors to consider taking on lower risk than they're currently taking in an overvalued stock market," Rosso says.

Currently, the Standard & Poor's 500 index is priced at around 25 times earnings, which is considerably higher than the median ratio of 14.7. Returns on stocks have not been great when the market is so pricey, at least on a historical basis. Also, stocks are generally considered riskier than bonds.

"If rising interest rates offer bond and short-term fixed income yields that are more attractive coupled with less risk, then investors may be motivated to seriously consider a trade-off between stocks and bonds," Rosso says.

How to adjust your portfolio. Not all investors have the same portfolio mix. But it seems likely given the past few years of roaring stock market returns that many have a large helping of stocks.

The trick is to work out whether a drop in the value of stocks would lead you to lose sleep or make you anxious. If it would hurt your emotions, then you have too big an allocation to stocks.

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For instance, if you had 90 percent of your portfolio assets in the SPDR S&P 500 exchange-traded fund (ticker: SPY) and the remaining 10 percent in the Vanguard Total Bond Market ETF ( BND), which tracks a broad basket of bonds. Then it probably would make sense to sell some of the S&P fund and buy more of the bond fund.

Simon Constable is a freelance economics and markets commentator for U.S. News & World Report. He has written for The Wall Street Journal, Barron's, TheStreet and Forbes, as well as many other well-known publications. He co-authored "The WSJ Guide to the 50 Economic Indicators that Really Matter," which was an economics category winner in the Small Business Book Awards at Small Business Trends. Constable is also a fellow at the Johns Hopkins Institute for Applied Economics, Global Health and the Study of Business Enterprise. You can follow him Twitter @simonconstable or find him on LinkedIn.