We're writing today to discuss a critically important aspect of the capital markets: interest rates. Broadly speaking, interest rates in the U.S. are at the highest levels we have seen since the Global Financial Crisis in 2007,¹ and it's worth discussing how this development may impact the economy and your investments in the coming year(s). To simplify matters, we will use a sailing analogy.

Think of the economy as a sailing ship, with interest rates acting as the wind influencing its course. When rates are high or even rising from previously low levels, it's akin to a headwind challenging the ship’s forward progress. This interest rate headwind on the economy trickles down to impact the performance of financial assets such as stocks and bonds.²

Stocks can be thought of as the engine driving the ship. Higher interest rates make it more difficult for companies to borrow funds, creating waves that may slow their growth and negatively impact stock prices. Additionally, higher interest rates can make bonds a more attractive alternative to stocks in investment portfolios,³ further weighing on the prices of stocks and other assets (i.e. gold, real estate).

Meanwhile, bonds generally play the role of stabilizers in your portfolio. But when interest rates rise, new bonds emerge offering better rates and interest payments, making existing bonds less valuable. This helps explain why many bond investments posted negative returns as rates rose over the past 18 months. Now that rates are higher and seemingly more stabilized,⁴bond investments could offer more compelling returns in the coming year(s). In fact, this surge in interest rates may prove to be one of the best financial and economic developments for retirees in 20 years.⁵ For this reason, we were actively rebalancing or even adding to bond allocations through the summer and fall of this year for many clients – particularly those who are more risk-averse or reliant on investment income for their retirement.

What should investors do in these choppier financial waters? As always, remain calm and maintain a focus on long-term goals. It's like adjusting the sails to navigate through changing weather conditions. While high interest rates may present challenges, remember every journey has its ebbs and flows. The time will come again when interest rates decline and this headwind will become a tailwind, as illustrated in the chart below.⁶ Here at Sapient we believe the “last mile” of the Federal Reserve’s battle with inflation could be the toughest, and thus delay rate cuts further into the future.⁷But since the exact timing remains uncertain, we believe it is prudent to properly balance investment portfolios now for the changing winds. The mix of factors driving portfolio returns in the next few years may well differ from those 2-3years ago, when interest rates were at historic lows.⁸

Thank you for allowing us to help navigate your financial voyage with great care.

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Sources:

1. Economist, Nov 2, 2023

‍https://www.economist.com/briefing/2023/11/02/markets-think-interest-rates-could-stay-high-for-a-decade-or-more

‍2. Investopedia.com, July 22, 2023

‍https://www.investopedia.com/investing/how-interest-rates-affect-stock-market/

‍3. Money.com, July 26, 2023

‍https://money.com/how-high-interest-rates-impact-stocks-bonds/

‍4. Fox Business, Dec 13, 2023

‍https://www.foxbusiness.com/economy/federal-reserve-interest-rate-decision-december-2023‍

5. Wall Street Journal, Dec 9, 2023

‍https://www.wsj.com/personal-finance/retirement/income-investing-bonds-dividend-stocks-01a97372?mod=hp_lead_pos11&utm_campaign=What%20I%20Am%20Reading&utm_medium=email&_hsmi=285932298&_hsenc=p2ANqtz-888FvyAVnZDXymR6smuO1vMgUKXEX7aL8ImbVIQTRwJsdWyeE47Ax3LrLpIeQ--dxJlwjTOgGWAGQ3G0rZR2-fOqayoQ&utm_content=285932298&utm_source=hs_email

‍6. Wall Street Journal, Dec 13, 2023

‍https://www.wsj.com/personal-finance/money-interest-rate-investment-stocks-bonds-4310b111?mod=hp_lead_pos3

‍7. Wall Street Journal, Dec 10, 2023

‍https://www.wsj.com/economy/central-banking/federal-reserve-cutting-interest-rates-when-4a910883?mod=hp_lead_pos7&utm_campaign=What%20I%20Am%20Reading&utm_medium=email&_hsmi=285932298&_hsenc=p2ANqtz-8jTcs8NlOuz4jQmSYrlj3-0Jvsq7TCEe-k0XcgcXvBTr-u3SHYQuLuDqZKMn8MRwEdhXALjL824OR4UXYgbaJGBlapZA&utm_content=285932298&utm_source=hs_email

‍8. Gurufocus.com

‍https://www.gurufocus.com/yield_curve.php

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Although the statements of fact and data in this report have been obtained from, and are based upon, sources that the firm believes to be reliable, we do not guarantee their accuracy, and any such information may be incomplete or condensed. All opinions included in this report constitutes the Firm’s judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Past performance is not a guarantee of future results. Indexes, such as the S&P 500 Index, are not directly investable.