US Fed | Equity Mutual Funds: How a US Fed Rate Hike Can Impact Your Equity Mutual Fund Portfolio

Stock markets have been very volatile lately. It is not only the COVID-19 pandemic that is impacting the Indian stock market, but even the looming geopolitical tensions and monetary policy normalization stance adopted by the central bank in the developed world are impacting the market.

In this article, let’s talk specifically about the potential impact of potential rate hikes by the US Federal Reserve on stock markets and your mutual fund portfolio.

The U.S. Federal Reserve began to scale back its bond purchases and signaled an interest rate hike as early as March 2022. The Federal Open Market Committee (FOMC) believes it would soon be appropriate to raise the federal funds target range and it has pledged to continue to reduce the monthly pace of net asset purchases to end them in early March 2022.

Indeed, inflation in the United States, which was supposed to be “transient”, reached a record level of 7.5% in January 2022 (the highest since February 1982). FOMC members worry about rising inflation and financial stability.

Later, a statement from the head of the US Federal Reserve, Jerome Powell saying that he is ”
it’s time to remove the transitory inflation termis an acknowledgment that inflation has not been transient as expected, and now may be the time to accelerate the roadmap for a reversal in the easy liquidity environment. It is unclear when interest rates will be raised; Views at the time could be different, but one thing is certain, there is an almost unanimous opinion in the capital markets that interest rates will rise.

As a result, yields on 10-year US Treasuries soared, causing capital to return to developed economies from emerging market economies such as India.

Over the past few months, particularly since the US Federal Reserve began scaling back its bond purchases in November 2021, we’ve seen foreign portfolio investors (REITs) selling stocks while domestic mutual funds were net buyers.

You see, whenever there are indications that the “helicopter money policy” will soon end and interest rates will rise, REITs generally prefer to take money off the table. This is because the cost of funds is expected to rise, which could impact the economy and stock markets (due to the classic inverse relationship between interest rates and the stock market). Furthermore, better bond yields are attracting the attention of investors in the debt markets.

That said, it is not always true that rising interest rates and stock markets show an inverse relationship.

Although several central banks raised interest rates in calendar year 2021, the equity market generated double-digit returns.

Speaking specifically about the impact of US Federal Reserve rate hikes on stock markets, historical data reveals that there are more times when markets have gone up than when they have gone down. Of the 12 rate hike cycles since the 1950s, the S&P 500 index has risen 11 times. That the pace of wealth creation may be lower than when helicopter monetary policy is adopted.

A point here is that rate hikes are usually made when signs of strength or strength are evident in macro indicators – better core sector growth, GDP growth, better corporate earnings, employment data, etc. . This bodes well for stock markets which help them generate wealth. Thus, it is not always true that the usual wisdom of rate hikes turns out to be detrimental to equity markets.

All that matters is taking calculated risks and selecting the right stock or equity mutual funds. As in the case of bonds where bonds with the longest maturity are the most sensitive to changes in interest rates, in the case of equities too, you should be wary of stocks with high valuations and those that are sensitive to increases. of the cost of capital. It is possible that some of the newly listed new-age companies (despite having a strong business case and huge opportunity size) may find it difficult to fund their growth by consuming cash in an environment where the cost of capital increases. At the same time, those with deep pockets or healthy financial coffers, large corporations or those intrinsic to the growth of the economy would show good long-term results.

A reasonably valued stock portfolio should outperform an expensive portfolio in a rising interest rate environment. Here’s when buying the idea of ​​value investing can work for you. In times of easy money politics, where people choose growth over value, value investing may not have generated value or built effectively for you investors. But let me tell you, when the going gets tough and interest rates rise, value investing would potentially work in your favor.

(The author is Fund Manager – Equity, Quantum Mutual Fund.)

Dolores W. Simon