A strong economy with rising inflation and interest rates should hurt some bond investors. While many bond investors strive for capital preservation, stability and yield, in recent years it was hard to find all three traits in the same security.
Some investors found higher interest rates in long-term emerging market and junk bonds. Amazingly, many emerging markets were even able to issue their own junk bonds. Over the next few years, rising interest rates, widening credit spreads and currency fluctuations could devastate the valuations of these bonds. Thus, some bond investors who reached for higher yields may find they forsook capital preservation and stability in the process.
Even investors in US Treasury bonds could experience pain. Locking in interest rates under 3% does not help if inflation returns to its 60-year average of 3.7%. While stated inflation rates were below the 60-year average in recent years, they can move above that average in the future. Consequently, buying and holding a US Treasury bond at today’s interest rates could result in a negative return after adjusting for inflation.
Moreover, selling a long-term bond after interest rates rise can result in a substantial loss. If the interest rate on the 30-year US Treasury rises just one percentage point (from about 3% to 4%), then the market value of the 3%, 30-year bond falls by 17%. When the 30-year interest rate is 4%, who would buy a 30-year 3% bond at full face value?
Some investments are thought of as bond substitutes due to a high stable yield and little-to-no growth. Many of these can also perform poorly when interest rates rise. As such, investors should avoid many utility stocks, preferred stocks, master limited partnerships and royalty income trusts.
Consequently, bond investors who value stability and capital preservation should focus on much shorter maturity bonds with a focus on investment grade, US dollar denominated securities.
Conversely, strong economic growth coincides with growing revenue, earnings and cash generation for many companies. Long-term, stock price returns have been correlated with earnings.
However, strong economic growth can also create inflation and tight labor markets. Currently, a shortage of truck drivers, changes in trucking regulation, and higher fuel prices have resulted in higher transportation costs for many companies. Rising wages and additional tariffs can also raise costs and cut into profit margins.
Investors should select stocks in companies that benefit from rising inflation, higher interest rates, a stronger consumer, technological innovation and increasing capital spending. Other attractive traits include: little debt, few variable rate loans, positive (and growing) operating cash flow and free cash flow, product pricing power and market-share leadership in a growing niche.
A portfolio of high conviction stock investments can benefit from the power of long-term compounding while still being diversifiedby market capitalization, economic sector or industry, geographic exposure, and cyclicality. Investors should still adhere to valuation, growth and/or dividend disciplines.