Inflation, Interest Rates and Income Investments - Cabot Wealth Network

Inflation, Interest Rates and Income Investments

For investors lulled into a false sense of security by the low-volatility bull market of 2017, the past week has been a rude awakening. Even for investors who remember much longer and much deeper market corrections (and us professionals!) Monday’s sudden drop was a little scary.

But as you’ve doubtless heard or read numerous times by now, there’s no reason to panic. For one thing, this correction comes on the heels of a market rally so strong that pretty much everyone agreed a pullback was around the corner.

What happens next? Very short-term, a bounce is likely, but you might want to use it to do some selling. And even though the bargains may be tempting here, I don’t recommend doing a lot of buying right now. That’s because intermediate-term, the market is pretty wobbly, and more downside or at least sideways action is possible. A longer market correction that further lowers investor sentiment would probably be healthy, while a consolidation period would allow the market to digest some of its 2017 gains.

But long-term, the trend remains up. Except in one area.

The Bond Bull Market Is Over

One commonly cited reason for this week’s market panic is a sudden surge in interest rates. Conventional wisdom says rising interest rates will eventually push stocks lower, and treasury yields are at their highest levels since 2014. The interest rate on the 10-year Treasury has already surpassed economists’ predictions for the third quarter 2018. But the key word here is eventually—rates and stocks can rise in tandem for years.

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Still, the uptrend in bond yields—and corresponding decline in their prices—looks like it’s finally here to stay. Bonds did bounce slightly Monday as panicky investors looked for safe havens, but they backslid Tuesday, as the one-day market bounce calmed investors’ raw nerves.

What’s Driving Yields Up?

Inflation is the number-one driver of higher interest rates. Inflation has been tame since the financial crisis, but economists expect it to pick up this year. While measures of current inflation are still below the Fed’s 2% target, expectations have risen sharply in recent weeks, driven by strong U.S. and international economic growth, the lowest unemployment rate in 17 years, an uptick in wages, the highest oil prices in three years, and weakness in the U.S. dollar.

The dollar recently hit its lowest point since 2014 after U.S. Treasury Secretary Steven Mnuchin said that a weaker dollar is good for U.S. trade. In addition to making U.S. exports more affordable (good news for U.S. manufacturers like Cummins), a weaker dollar could contribute to inflation and lower international demand for U.S. Treasuries, driving interest rates up. (It’s good news for commodities though, which are mostly priced and traded in dollars, causing prices to rise when the value of a dollar declines.)

Treasury yields are also affected by supply and demand for Treasuries themselves. Right now, the Treasury is issuing Treasuries at the fastest rate in years, increasing supply. The increased debt is necessary to finance a budget deficit enlarged by the recent tax cuts.

Bond dealers expect the Treasury to eventually issue at least twice as many Treasuries this year as in 2017, according to Bloomberg News.

What Comes Next?

While it seems that yields have finally started a new long-term uptrend, there are still plenty of events that will cause volatility in the short- and medium-term.

Jerome Powell just became Fed Chair on February 3, and while investors currently expect more of the same from him, any change in the Fed’s tone or the language in their statements will be analyzed closely.

Then of course there’s inflation itself, which still hasn’t begun a convincing uptrend. If real inflation measures don’t catch up to expectations over the next few months, all the economists’ predictions could go out the window.

In short, interest rates have been trending down since 1981, so while a reversal will impact many asset classes, it won’t happen overnight. Income investors—like all investors—should stay informed about the factors affecting interest rates, without overreacting to every wiggle. But there are a few asset classes that investors may want to avoid.

Why Have REITs and Utilities Been Declining?

Since the start of the year, high yield investments including utilities and REITs (real estate investment trusts) have been significantly underperforming the broad market. REITs and utilities have a few things in common.

Both tend to carry high debt loads. The average debt-to-equity ratio in the utility industry is 0.9, while REITs tend to have debt-to-equity ratios of 1.0 or greater.

Both use these borrowed funds to make large capital investments (in infrastructure or real estate) that then generate predictable income streams (utility payments or rents.)

These predictable income streams make utilities and REITs excellent dividend payers.

However, the companies’ high levels of indebtedness leave them vulnerable to changes in interest rates. When interest rates rise, the companies must refinance maturing debt at higher rates, which raises their costs.

So investors worried about rising interest rates should think twice before investing in REITs and utilities.

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