In this week’s newsletter, I am going to discuss the impact of rising rates on the market.
We’ve seen a massive correction in many of the hot tech stocks that had run up by over 100%. In some cases, they’ve now dropped by as much as 50%.
For example, Tesla, the market’s golden child, dropped more than 20% and entered into this new bear territory. Experts have attributed these types of corrections to rising interest rates. You may recall that in my previous newsletter, I discussed the potential impact rising rates could have on the market. This very week, we’ve started to see some of that materialize. So then, you may ask, what exactly is happening?
Quite simply, many investors are fearful of inflation. In an inflationary environment, bonds and other fixed income assets become less and less valuable because although what you receive in the future will remain the same, your purchasing power is decreasing due to inflation. Therefore, investors dump their bonds, and that puts a downward pressure on prices. There’s an inverse relationship at play. When prices go down, the yields go up. (If you would like a more detailed explanation about why this happens, please email me and I will be more than happy to discuss this subject further and answer any questions you might have.) Likewise, when yields go up, valuations end up being compressed. The reason for this is that stock prices are the future cash flow of a company discounted back, and when the rates rise, the denominator will get bigger, which in turn will make the whole equation smaller. I tried to visually show this relationship in the image below.
Given all of this, how worried do you have to be?
As I mentioned two weeks ago, we will experience some inflation in the coming months. The reasons for this include:
- The economy is opening back up. In most jurisdictions, more and more people are being vaccinated and now there is the new J&J vaccine to add to the mix.
- Disposable income is up 11.5% month over month and consumer purchasing power is thus increasing.
- Housing prices are moving up at a double-digit rate.
- More stimulus funds are coming. The fiscal policies of most governments at the moment lean toward more spending (and larger deficits).
All of this will lead to some inflation, which I assume will probably be higher than 2% for a short period of time, but in the long run, deflationary forces are much stronger. Technological advancements and global trade are two of the reasons why we did not experience any major inflation following the Fed’s 2009 quantitative easing program, and that is also why we are less likely to see any consistent inflation above 2% in upcoming years.
I also believe ten-year yields may continue to move higher and impact more of the companies whose valuations were looking a little bit dreamy!
This could very well be a great time for you to take a look at your portfolio and do the necessary reallocation to make sure you are well diversified and do not have unnecessary exposure in any one specific sector.
To your success,