Inflation and interest rates should continue to increase as increased lending, repatriated funds, lower taxes, higher government spending and rising consumer spending add to economic growth.
In general, this environment is good for the stock prices of companies that can grow their profit margins and bad for the prices of fixed-rate long-term bonds.
If interest rates rose one percentage point, then today’s 30-year US Treasury bond yielding almost 3% would have its market value decline by over 17%. Why pay full price for a 30-year 3% bond, when long-term interest rates are 4%? Of course, the loss would be even larger if interest rates rose by more than a percentage point.
Similarly, investments used as bond replacements, like preferred stocks and utility stocks, should also underperform in a rising interest rate environment.
Inflation from rising labor, rent and raw material costs will hurt many corporations. The companies which cannot raise the sale prices of their goods and services could experience declining profits. Consequently, their share prices may fall.
Of course, there are some companies that benefit from rising interest rates, and others that benefit from rising inflation. Investors should also focus on stocks of companies that:
- Have an attractive entry valuation
- Dominate their growing niche markets
- Generate recurring sales, earnings and cash flow growth
- Use cash profits to reinvest in future growth opportunities
- Use excess cash to retire debt and reward shareholders
- Have experienced managements with a vested interest
A portfolio holding investments with these attributes can still achieve several types of diversification, such as:
- Geographic – by country of incorporation or location of sales and profits
- Market capitalization – large, mid and small-capitalization stocks
- Investment style – growth, value and/or income
- Economic sector or industry – such as consumer discretionary, financials and technology
Portfolios of select holdings can concentrate on many positive traits while also achieving these four types of diversification.
Investors can dilute their efforts by over-diversifying. By owning a bit of everything, investments in companies with negative traits could damage overall results. On the other hand, being more selective allows high conviction ideas to have a greater impact. Investors should adhere to proven strategies that have long-term audited returns.