People get used to the way things are and often have trouble adapting to change.
Take interest rates for example. For much of the last 15 years since the financial crisis the Federal Reserve rate has been close to 0%. While it is historically unprecedented for rates to be this low, not to mention for so long, many people have come to think of it as normal and the way things were always going to be.
What a difference a year makes! To fight inflation, the FED rate (on which all other rates are based) has now been pushed above 5%. That is probably the fastest rise in history, and it has upended the investment playbook used by many since the 2008 financial crisis.
Because rates on money market and bond funds were low to non-existent prior to last year, stocks were seen as the only way to make any money. High inflation and rising rates have created a new investing environment that could be with us for some time.
Key questions now are:
- When will inflation decline to acceptable levels?
- How high will rates go?
- How long will rates stay at current levels?
- Will the economy fall into a recession and how severe might it be?
- What will it take for the banking sector to stabilize?
We will not pretend to know the answers to these questions, but we will continue to watch things closely for clues.
What is clear is that the risk level has risen, and a defensive position is warranted which means:
- Holding low levels of stock and focusing on financially strong companies which are more likely to weather the challenges ahead.
- Using alternative investments without many of the risks of stocks and longer-term bonds.
- With rates closer to probable peak levels, add money to intermediate term bonds to lock in higher rates for longer.
- Continue to maintain a significant allocation to short-term bonds given high short-term rates and liquidity that allow us the flexibility to move funds to more attractive areas in the future.
Fortunately, the higher Fed rate means much higher income on short-term bonds with minimal risk while we wait for better long-term opportunities.