Should you worry about rising interest rates?

Despite holding off last month, the Federal Reserve is likely to raise interest rates soon. 

Although it held off doing so last month, the Federal Reserve is still likely to raise interest rates later this year or in early 2016. Assuming it does, how should investors respond?

One justification used by the Fed to reduce interest rates to zero was that it would increase the prices of assets such as houses and shares. By increasing people’s wealth, this would in turn lead them to spend more and result in higher economic growth.

Relatively slow economic growth in the U.S. in recent years suggests this policy hasn’t been a raging success, yet it’s likely many stocks are more expensive than they otherwise would be in a more normal interest rate environment. And with Australian bond rates greatly impacted by U.S. bond rates, any rate increases in the U.S. are likely to impact us here in Australia too. 

Stocks which are particularly sensitive to the level of interest rates – such as utilities and listed property trusts – are likely to be the most affected by any future rate rises. 

For instance, with low interest rates making their distributions more attractive compared to bonds and cash as well as pushing up property prices, most listed property trusts such as Scentre Group (ASX: SCG) and Goodman Group (ASX: GMG) don’t appear to be good value at current prices.

Low interest rates have also increased the multiples investors are willing to pay for many growth stocks.

Moreover, financial theory states that the value of any company is the present or discounted value of its future cash flows. All things being equal, higher interest rates should increase the rate at which future cash flows are discounted and so reduce the price investors are willing to pay for stocks.

With due respect to financial theory, however – and ignoring stocks such as utilities and listed property trusts – if you’re someone who invests in high quality companies and intends to hold them for many years, if not decades, then worrying about the future direction of interest rates is a total waste of time.

Instead, you should concentrate on analysing a company’s underlying business, its competition, the quality of management and so on. If you believe you’ve identified a high quality company – such as one whose dominant market share gives it pricing power and allows it to generate high returns on invested capital and lots of free cash – then you should consider buying it if it’s available at a reasonable price.

Holding a diversified portfolio of such companies over the long term will mean future interest rate movements have little effect on your investments. And so you can comfortably ignore whatever Janet Yellen and the Fed do in coming months.

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