Interest Rate Environments and Asset Allocation

Asset allocation is the cornerstone of a sound investment strategy. Dividing a portfolio between different asset classes such as stocks and bonds, as well as other assets, is one of the primary methods of diversification.

Many factors can influence how an investor allocates their money, but one thing they should potentially consider is the prevailing interest rate. Understanding how to navigate different interest rate environments is vital in constructing a resilient portfolio and minimizing volatility.

Let’s look at how varying interest rate environments affect asset allocation decisions, and how investors can position their portfolios in response to interest rates.

Understanding rate environments

The interest rate environment refers to the general level of interest rates in an economy, which results from actions by central banks like The Federal Reserve. Central banks adjust key interest rates as a part of monetary policy to manage the economy and control inflation.

When a central bank adjusts the benchmark interest rate, the effects flow through the economy. The change in the interest rate influences borrowing costs for consumers and businesses, impacts corporate profits, and affects consumer spending habits. For investors, changes in the interest rate directly affect the performance of different asset classes, making the rate environment a critical factor in a strategic asset allocation.

Navigating a low-interest rate environment

A low-interest rate environment occurs when the risk-free rate is lower than the historical average for a prolonged period. Central banks lower rates to stimulate economic activity, often during periods of slow growth or deflationary pressure. For example, following the 2008-2009 financial crisis, the United States and much of the world experienced a low-rate environment.¹

Impact on asset allocation

• Equities: Lower rates have historically typically supported stronger stock market returns, particularly for growth stocks.² The cost of borrowing declines for companies, making it less expensive to fund expansion and reducing interest expense. Moreover, the lower rates have an impact on the discount rates used in valuation models, which results in higher valuations.
• Fixed Income: When interest rates decline, bonds and other fixed-income securities may become less attractive.³ When bond yields decline, investors often look to riskier assets to pursue more attractive returns.  
• Real Estate: Lower rates can have a positive impact on the real estate market.⁴  Mortgages should become less expensive, making home ownership more accessible and fueling demand. Investors may be attracted by potential rental income and the potential for appreciation.
• Alternative Investments: Historically, interest in private equity, hedge funds, and commodities has risen in low-rate environments.⁵ The environment can be considered supportive, and investors may seek diversification and higher return potential beyond the traditional public markets.

Risks to consider

While a low-rate environment can engender investor enthusiasm, it also introduces risks. When rates remain low for a long period and the market is flooded with cheap money, assets can become overvalued, and this can lead to potential market bubbles. For conservative investors who rely on income, such as retirees, the scarcity of yield from safe assets like government bonds can present a significant challenge.

Positioning for a rising rate environment

When the economy is in danger of overheating, central banks historically have raised rates interest rates as a cooling mechanism in an attempt to help prevent inflation from getting out of control. The Federal Reserve's series of rate hikes that began in 2022 is an excellent example.⁶

Impact on asset allocation

• Equities: Higher interest rates potentially have a dampening impact on the stock market. Value stocks may begin to outperform growth stocks. Borrowing costs become higher and companies may see their interest burden increase, with a negative impact on profitability. They may postpone investment necessary for growth. Higher interest rates also reduce the present value of future earnings, which disproportionately affects growth companies whose valuations are based on long-term profit expectations.
• Fixed Income: This can be a tricky period for bondholders. As interest rates rise, the prices of existing bonds should fall. However, new opportunities may emerge. Shorter-duration bonds and floating-rate instruments, whose payments adjust with interest rates, can become more appealing.
• Real Estate: Higher borrowing costs for mortgages can dampen buyer demand, potentially leading to slower price growth or even declines. The real estate market can cool appreciably.
• Cash: Holding cash or cash equivalents becomes more attractive. As rates rise, you can earn a higher, low risk return on savings, making cash a viable part of an allocation strategy.

Risks to consider

Perhaps one of the greatest risk in a rising-rate environment is increased market volatility. The transition from cheap money can be challenging, and aggressive rate hikes can put the brakes on the economy. Companies with high levels of debt may struggle as borrowing costs increase, creating challenges for specific sectors.

Investing in a high-interest rate environment

A high-interest rate environment is characterized by sustained high rates, which are implemented to check persistent inflation. Perhaps the best example is found in the early 1980s, when Federal Reserve Chairman Paul Volcker raised rates dramatically to conquer double-digit inflation.⁷

Impact on asset allocation

• Equities: Defensive sectors have been popular during periods of high inflation.⁸ Companies in industries such as utilities, healthcare, and consumer staples, which have stable cash flows and provide essential goods and services, have historically tended to be more resilient during economic slowdowns caused by high rates.
• Fixed Income: Bonds have typically outperformed in a high-rate environment.⁹ High yields can make fixed-income investments quite attractive, particularly for investors focused on generating a steady stream of income. Locking in high yields may provide reliable returns for years.
• Real Estate: The property sector generally faces significant headwinds. High financing costs for both developers and buyers can severely depress activity and valuations.
• Commodities: Certain commodities can potentially provide effective hedges against inflation. Gold, energy, agriculture, and industrial metals are often recommended.¹⁰

Risks to consider

To us, the most significant risk that accompanies a high-rate environment is the potential for recession. Tight monetary policy is designed to slow the economy, but sometimes central banks may overcompensate. This can lead to lower economic growth, higher unemployment, and limited access to capital for businesses and consumers.

Adapting your strategy for any environment

Consider the role of active management, which can help you navigate interest rate movements by adjusting allocations. Also, make it a policy to keep an eye on economic indicators and monitor communications from the Fed. Rebalancing your portfolio periodically can help you make sure your investments remain consistent with your long-term goals as market conditions evolve.

The takeaway

Interest rates are a powerful force in the financial markets, and their movements can have a profound impact on asset allocation. Low rates may favor risk assets like growth stocks and other equities, while rising rates may create volatility but offer opportunities in value stocks and cash. Higher rates can make bonds and defensive equities more appealing.

The truth is, no one can forecast interest rates or the market’s response. All investing involves risk and may lose money. Past performance is not a guarantee of future performance. That’s why it’s essential to build a flexible, resilient portfolio grounded in timeless investing principles like diversification, because different assets perform differently across rate environments, helping to mitigate overall risk.