Preparing Your Household For a New Era of Rising Interest Rates

A financial sea change may be on the horizon. After approximately four decades of declining interest rates, we might be at the cusp of a long-term debt cycle shift that could see interest rates rise for multiple decades, reminiscent of the period between 1945-1980. In this article, we'll delve into the potential impacts this shift could have on your household wealth and provide guidance on how to navigate this new era.

The Possible Consequences of Rising Interest Rates

As rates continue to rise over the long term, we can anticipate the following outcomes:

• A drop in equity multiples (Price / Earnings or EV / EBITDA) for mature companies with low growth rates.

• Higher capitalization rates in real estate (i.e., lower prices) for mature properties.

• Higher yields for fixed-income securities, as well as lower returns and/or losses for securities with significant duration (i.e., bonds with maturity dates far into the future are likely to lose value).

• Cash equivalents (like Treasury Bills) are likely to produce reasonable returns relative to other asset classes.

A Look Back at History

The Federal Funds Rate

Source: Bloomberg (FEDL01 Index)

Between 1962-1980, the S&P 500 P/E ratio dropped from 21x to 7x, as short-term interest rates skyrocketed from 3% to 19%. This historical trend supports the expectation that earnings yields and long-term bond yields tend to remain in similar ranges over extended periods. Consequently, earning yields should rise as interest rates rise, while P/E ratios decline.

Source: Bloomberg, Ahara Advisors

S&P 500 Earnings Yield vs. 10-Yr Treasury Yields (1962-1980)

Source: Bloomberg, Ahara Advisors

Note: The return analysis is based on the time period between 3/30/1962 – 12/31/1980

During this time, rising interest rates posed significant challenges for equities. For instance, cash (as measured by short-term treasury bills) outperformed the Dow Jones Industrial Average over two decades. While the more diversified S&P 500 slightly outperformed cash during the same period.

Source: Bloomberg, Ahara Advisors

Note: The return analysis is based on the time period between 12/31/1959 – 12/31/1980

Thriving in a Rising Interest Rate Environment:

To weather the potential storm of rising interest rates, consider focusing on investments that share the following characteristics:

• Growth in underlying earnings/revenue that surpasses the drop in valuation multiples.

• Purchase prices that underestimate the long-term business potential.

• Borrowings at low, long-term, interest rates.

By targeting companies with these attributes, families can position themselves for a future with higher interest rates. On the other hand, it's wise to steer clear of investments trading at high multiples with low expected growth, including long-maturity bonds with low yields.

The prospect of a multi-decade period of rising interest rates might seem daunting. However, by understanding the potential impacts on your household wealth and making informed investment decisions, you can successfully navigate these financial waters and secure your family's financial future.