The aggressive rising pace of inflation in the market means that investors will need a new strategy to keep their portfolios afloat. Historically, the effect of high inflation over the long term is somewhat nebulous – stocks seem to be able to eventually absorb the impact of higher rates and adjust to the new economic environment relatively well. The short-term impact of inflation in the markets is where things become more complicated.
In general, rising rates means higher volatility for stocks and can often lead to lower values – at least, temporarily. This happens because higher interest rates means that companies must pay out more money for interest-driven expenses and leads to more expensive loans that need to be taken out in order to do business.
The extra expense translates to lower earnings, which means one of two things needs to happen: either stock values fall to adjust for the reduction in earnings or valuation multiples rise as investors essentially pay more for fewer future earnings. In the first case, investors will see the impact of higher rates relatively quickly. In the second case, higher multiples may help to prop up the stock’s price for a while, but may ultimately lead to higher volatility down the road. Investors can end up experiencing greater losses than anticipated if that last scenario plays out over a longer period of time.
The first reaction investors are likely to have in a possible market correction might be to buy defensive dividend-paying stocks, but those are the most vulnerable to under-perform first. Higher interest rates means that the dividend yield on a stock is under pressure. In order to maintain the same relative payout level, the company would need to boost dividends. The same problem happens with bonds – as rates go up, bond values drop.
Right now, the yield of a 10-year Treasury is 2.8% – otherwise known as the “risk-free rate.” That means that investors assume higher-than-average risk to buy stocks that come with a dividend yield of 2.8% or less. After all, why take on the risk of the stock falling when you can achieve the same yields in a safe-haven asset?
But dividend investors aren’t completely out of luck. There are still some places where owning a dividend-paying asset is worth the additional risk.